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How much house can you afford?

The simple rule of thumb is to spend less than three times your gross income on a home.

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I’m here to show you the guts behind that little guestimate/guideline and give you some insight as to how your lender may determine whether it agrees with how much house you think you can afford. I’m going old school with pencil, paper and a wonky little calculator app. Follow along with your own calculations, if you wish, to answer the question, how much house can you afford?

Lenders consider lots of factors when they evaluate a loan application, among them, their borrowers’ Total Debt-to-Income Ratio (DTI). This magic number compares the total amount of debt you’re obligated to pay each month with your gross monthly income (income before taxes and other deductions).

 DTI Calculation
$ Total Monthly Debt
÷ $ Total Monthly Gross Income
DTI Ratio (%)

Lenders may allow up to 43% for a Total DTI Ratio. But there’s no need to be an overachiever and hit that maximum. Do yourself a favor and try to keep your Total DTI Ratio low. Consider a conservative cap of 38%.

The lower you keep this number, the more financial freedom you’ll have with regard to saving and your living expenses. And don’t forget you may need to furnish your new home or buy a lawn mower or a new toilet.

What counts toward Total Monthly Debt?

Total Monthly Debt includes your Proposed Monthly Housing Expense and the rest of your debt.

 Total Monthly Debt calculation
$ Proposed Monthly Housing Expense
+ $ Total of All Other Monthly Debt
$ Total Monthly Debt

We’ll circle back to Proposed Monthly Housing Expense; as for All Other Monthly Debt, include the following monthly payments in your tally:

  • Student loans
  • Car loans or leases
  • Bank credit cards, like VISA and MasterCard
  • Department store credit cards, like Target, Best Buy and Macy’s
  • Alimony or child support
  • Other housing expense, a second home, for example

Your lender may have additional requirements with regard to what it considers as monthly debt.

Don’t include your current rent payment or monthly living expenses like groceries, utilities, cell, cable, entertainment or gym membership. You’ll need to consider your living expenses in your total monthly budget but your lender will not use them to calculate your Debt-to-Income Ratio.

Here’s an example:

Type of debt Monthly payment
Student loan $300
Car lease $250
Bank credit cards $50
Department store credit cards $25
Total of All Other Monthly Debt $625

Let’s say your gross annual income is $50,000; your gross monthly income, $4,166. Based on that figure, your All-Other-Monthly-Debt-to-Income Ratio would look like this:

$620 Total of All Other Monthly Debt
÷ $4,166 Total Monthly Gross Income
15% All-Other-Monthly-Debt-to-Income Ratio

My, what a lovely, manageable ratio.

Circling back to Total DTI Ratio and Proposed Monthly Housing Expense

So if your Total All-Other-Monthly-Debt-to-Income Ratio is 15% and you set a cap of 38% for your Total DTI Ratio, you should be able to comfortably afford spending 23% of your gross monthly income toward your monthly housing expense.

Here’s how that works out, based on our example:

 Proposed Housing Expense Calculation
38% Total DTI Ratio
15% All-Other-Monthly-Debt-to-Income Ratio
23% Proposed Monthly Housing Expense
x $4,166 Total Monthly Gross Income
$958 for monthly house payment

That $958 has to cover:

  • Principal and interest (P & I)
  • Real estate taxes
  • Hazard insurance (also called homeowners insurance), flood insurance and government (FHA) or private mortgage insurance
  • Miscellaneous expenses, such as secondary financing, homeowners’ association dues, cooperative corporation fee (net of individual utility charge), special assessments and ground rent

Back to the Rule of Thumb

The thumb tells us that with a gross income of $50,000, you could afford a house valued at $150,000 or less. Depending on local home values and real estate tax rates, miscellaneous expenses and your down payment amount, $958 a month may be plenty or it could be nowhere near enough. Let’s see where that amount will get you based on national medians and averages:

In the examples below:

  • The loan is a 30-year fixed-rate mortgage with an interest rate of 4%
  • P & I is based on calculations from homebuyers.mgic.com
  • Real estate tax (RE Tax) estimate is from wallethub.com
  • Homeowners insurance (HOI) estimate is from valuepenguin.com
  • Private monthly mortgage insurance (Private MI) costs from mgic.com are based on a 720 credit score and standard Fannie Mae MI coverage levels (35% for 97% LTV, 30% for 95% LTV, 25% for 90% LTV and 12% for 85% LTV)
Example: Financing with a 20% down payment
% Down 20%
$ Down $30,000
Loan Amount $120,000
P & I $573
RE Tax ($119) + HOI ($53) $172
Private MI N/A
Total PITI $745
Difference from Proposed $958 Monthly Housing Expense
– $213

 

Example: Financing with less than 20% down, private mortgage insurance
% Down 3% 5% 10% 15%
$ Down $4,500 $7,500 $15,000 $22,500
Loan Amount $145,500 $142,500 $135,000 $127,500
P & I $695 $680 $645 $609
RE Tax ($119) + HOI ($53) $172 $172 $172 $172
Private MI $115 $87 $56 $24
Total PITI $982 $939 $873 $805
Difference from Proposed $958 Monthly Housing Expense + $24 – $19 – $85 – $153

Private mortgage insurance is most often paid monthly and by the borrower — that would be you — and is included in the total monthly mortgage payment (Total PITI).

Something to note is that private mortgage insurance is cancellable. In our examples, depending on the down payment amount and an annual home price appreciation rate of 3%, it could be cancelled between months 33 and 61, reducing your mortgage payment by the monthly MI amount — a nice little bump in disposable income!

So how much house can you afford?

(Yes, the end of this post is finally here — thanks for sticking with me.) Our examples show that if you have a gross income of $50,000 and a Proposed Monthly Housing Expense of $958, financing a $150,000 home with the right down payment and financing combination is very do-able.

Of course, the greater the down payment is, the lower the mortgage payment. If you’re fortunate enough to have funds for a 20% down payment, you could comfortably afford a $745 monthly mortgage payment. The $213 cushion gives you some options, including increasing your home price budget. If you’re feeling particularly creative, you may consider financing with mortgage insurance, putting less down and using some of the funds for fixing up and furnishing your new home or for investments.

If you’re far away from a 20% down payment, our example provides good hope. You can stay at or well within budget with a much lower down payment. Less money to save for your down payment can shorten your path to homeownership.

As you go through your own example, you may want to play with bumping up your Proposed Monthly Housing Expense Ratio cap in small increments or reducing your loan amount to see where that gets you. You may also want to check on actual real estate taxes and homeowners insurance costs in your area.

Your calculations could reveal that you may not quite be ready to purchase a house. And that’s okay, because now you have the opportunity to assess and evaluate your monthly debt and living expenses. Maybe pay down some of your credit cards. Maybe trim a bit off your entertainment budget. It’s all in preparation for being an attractive candidate for a mortgage — but more important, to be able to buy a home of your own.

Notes:

  • There are a bevvy of calculators available that can provide you an answer to the question, how much house can you afford?, but they generally provide a maximum amount — one that may put a strain on your savings goals or your day-to-day living expenses
  • I made up the term “All-Other-Monthly-Debt-to-Income Ratio”; you will not hear these words coming from your loan officer’s mouth
  • I rounded numbers to the nearest whole number