How much house can I
To understand how much
house you can afford, you need to take into account two
important factors — what lenders will approve you for and what
fits within your budget. The good news is that these budgetary
guidelines typically line up. Even so, you will need to make
sure you don’t take on more house than you can afford just
because the lender is willing to approve a loan for that amount.
Lenders look at a long
list of criteria to determine the amount of house they’re
willing to approve you for. The list includes things like your
current monthly debt payments, your total debt, your income,
your credit score, your current assets, how much of a down
payment you can make and the current status of the economy.
1. The 5 Cs of lending
According to Wells
approval can be summarized as the five Cs —
credit history, capacity, collateral, capital and conditions.
Credit history is your
credit score and your past borrowing history can be found in
your credit report. Capacity refers to what you can afford.
Often, this is a look at your debt-to-income ratio — how much
you are paying in debt monthly versus how much income you are
Collateral in a home
purchase will be the physical home you are buying, which becomes
collateral the bank or lender can seize when you don’t repay
your loan. Capital deals with what other assets you might have
to help with repayment of the loan, and conditions are the
purpose of the loan, the market environment and the status of
2. The rule of 20
A rule that may be
somewhat antiquated — but is still widely cited as important —
is the rule of 20. According to this rule, homebuyers should not
purchase a home unless they are prepared to make a 20% down
payment on top of the additional costs associated with
purchasing the home. For example, if you are looking to buy a
$300,000 home, under this rule, you should be prepared to make a
down payment of $60,000.
However, this rule is
rarely the case these days. According to the
2019 National Realtors Association Report, 86% of
homebuyers financed their home purchase, and the average down
payment was 12%. For first-time home buyers, 94% financed the
purchase, and the average down payment was 6%.
The reality is that
you’ll often get a better interest rate and be in a much
stronger financial position if you’re able to put 20% down on a
home purchase. Is it completely necessary? 86% of homebuyers
don’t think so. You’ll need to assess your unique financial
situation to see if the rule is fully applicable.
3. The rule of 28/36
With the rule of
28/36, prospective home buyers compare their gross income with
their expected house payment and other debt responsibilities.
Under this rule, no one should purchase a home where their
housing expense would be more than 28% of their monthly gross
income. As a reminder, gross income is the amount you make
Note: the rule
mentions housing expenses and not just your mortgage payment.
This would include things like property taxes, homeowner’s
insurance, homeowner’s association fees and community
development fees. It does not include things like utilities.
For example, if you
bring home $5,000 in income a month before taxes, the total of
your mortgage payment and other housing expenses outlined above
should not be over $1,400.
The second half of
this rule looks at your total debt responsibilities you’ll owe
for the month, including the cost of the new purchase. The total
amount of these monthly payments should not exceed 36% of your
monthly gross income. This should include expenses like credit
card bills, student loan payments, car payments and any other
form of regular debt payment you are obligated to make.
How to calculate your
home budget based on income
A popular way of
answering the question, “How much mortgage can I afford?” is to
look at it as a percentage of your income. This method is quite
similar to the first half of the 28/36 rule, but it does not
include additional housing expenses.
Step 1: Add up your
total monthly income
Add up all of your
different sources of monthly income. This includes your
paycheck, your significant other’s paycheck (if you have one and
they contribute to your household, that is) and any side hustle
money that you’re earning on a regular basis. Calculate this
number without including taxes or other deductions taken from
Step 2: Multiply that
number by 25%
Once you’ve calculated
your total gross monthly income, multiply that number by 25% or
Step 3: Use this as a
guideline when shopping homes
The number you get
from this calculation should be the maximum you spend on your
monthly mortgage payment. It’s important to note, though, that
this does not mean it’s the amount you must spend. It’s
completely acceptable to spend under this amount.
The hidden costs of
buying a home
It’s easy to overlook
many elements of the home buying process and think the only cost
of buying a home is your mortgage payment. These hidden costs
need to be calculated into your budget too, or you may find
yourself short on cash in a situation where you thought you were
These hidden costs
include things like homeowner’s association (HOA) dues,
community development fees charged by the neighborhood,
homeowner’s insurance premiums, moving costs, closing costs,
landscaping costs and property taxes.
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