How Much House Can I Afford? – Home Affordability Calculator

How Much House Can I Afford? – Home Affordability Calculator

House hunting is a bit like dating. Sometimes, you fall for the wrong person – or the wrong house. It’s not at all unusual to fall head over heels in love with a house that’s way out of your budget. You feel like you just have to have it, so you pull every string you can to get approved for a bigger mortgage.

But once you’re settled into your new, beautiful home, you discover that you can’t relax and enjoy it. You’re too busy struggling to make those high monthly mortgage payments. You have no money left for fun, and you’re constantly stressed about paying all your bills. That’s when the romance turns sour.

To avoid being caught in this kind of bad relationship, you have to plan ahead. Before you start shopping, figure out how much house you can afford. Then make sure you stay within your home-buying budget by refusing to look at anything outside your price range. That way, you won’t risk being swept off your feet by a house that will only break your heart.

When you buy more house than you can afford, you’re not just putting your financial future at risk. You’re also sacrificing your happiness in the here and now. Here are some of the problems that come with an overpriced house:

money jar for saving money

It’s tempting to assume that the easiest way to figure out how much house you can afford is to ask your mortgage lender. After all, you figure, they’re the experts. If they say you qualify for a $300,000 loan, that must mean you can afford a $300,000 mortgage.

Unfortunately, mortgage lenders aren’t the best people to ask. They make their money by making loans, so it’s in their interest to get you to take out as big a loan as possible. To do this, they can juggle all kinds of figures – interest, points, income – to come up with a monthly payment that just fits into your budget. If you have to stretch every month to make your house payment, well, that’s not their problem, as long as you keep making it.

This isn’t to say that all mortgage lenders are dishonest. Most of them aren’t setting out to trick you into a loan you can’t afford – at least not on purpose. But they still have every reason to encourage you to borrow as much as you can. Also, they just don’t know as much about your financial situation as you do.

That’s why it pays to double check the bank’s figures by doing the math yourself. Look at your finances, crunch the numbers, and come up with a payment that fits easily into your budget – not one you’ll be struggling to meet.

All lenders use the same basic formula to figure out how much house you can afford. It’s called a debt-to-income ratio, or DTI. This is the percentage of your monthly income that goes toward paying all your debts, including your mortgage.

Here’s an example. Lou and Christy have a combined monthly income of $7,400. Out of this, they pay:

However, if they add a monthly mortgage payment of $1,500, their total debt payment rises to $3,350. That would bump their DTI up to more than 45%. In other words, nearly half their income each month would be going toward their debts. Most banks would agree that’s way too much, so Lou and Christy probably would not qualify for this mortgage loan. Dividing their total debt by their $7,400 income, their DTI right now is 25%.

However, if they pay off some of their other debts, things look brighter. For instance, if they can pay off one of their student loans, that would drop their total debt to $2,750 a month, for a 37% DTI. Paying off both student loans would drop their debt to $2,150 a month and their DTI to 29%. That’s an amount most banks would approve.

To figure out how much house you can afford, banks calculate your DTI in two different ways. First, they look at what they call the “front-end ratio.” This is the amount of your income that your monthly housing payment – principal, interest, taxes, and insurance – would take up all by itself.

The usual rule is that your payment should not come to more than 28% of your total income. For example, look at Lou and Christy. Their monthly income is $7,400, and 28% of that is $2,072. That’s the maximum they could spend on a house payment if they had no other debts.

However, Lou and Christy do have other debts, which also eat into their income. To account for those, banks use the “back-end ratio.” This is the amount of your income that goes toward all your debts combined.

Most banks say this total should not add up to more than 36% of your total income. For Lou and Christy, that amount would be $2,664 per month. However, their other debts already cost them $1,850 per month. That leaves only $814 per month for them to spend on their mortgage.

Luckily for them, there’s a loophole. Banks are often willing to stretch the back-end ratio to as much as 43% for “qualified mortgages.” These are mortgages that meet certain rules that make them easier to pay. For example, they cannot be balloon mortgages or loans with an interest-only period.

Using this rule, Lou and Christy could pay up to $3,182 a month on all their debts. Minus the $1,850 they pay now, that leaves them $1,332 per month for a house payment.

Even if you can qualify for a loan that gives you a 43% DTI, that doesn’t mean it’s a good idea. If you devote this much of your monthly income to debt, you’ll only have 57% left to cover all your other needs. You need to figure out if this is enough to live on before making a decision.

To determine what you can afford, consider these factors:

As you can see, there are a lot of factors that affect your monthly house payment. Trying to add them all up and figure out what you can afford can be incredibly complicated. At some point in the process, it’s tempting to throw up your hands and decide to go with the bank’s estimate after all.

Fortunately, you don’t have to do all this math yourself. There are lots of affordability calculators online that can do it for you. All you have to do is punch in some information about yourself, such as your income, debts, and down payment. Then the calculator crunches the numbers and tells you how much house you can afford.

One of my favorite calculators is from Zillow. The affordability calculator at Zillow has two versions:

In some cases, seeing how much house you can afford is a rude awakening. It can even be depressing if the total is so low that there’s just nothing in your area that fits into your price range.

Fortunately, there are ways around that problem. If you set your financial house in order before you start house-hunting, you can stretch your budget to cover a lot more house. Here are a few steps to take.

First, make sure you build up an emergency fund. Owning a home is expensive – and unpredictable. You never know when your roof is going to start leaking or your water heater is going to give up the ghost. Without a cash cushion, you’ll have to rely on credit to pay for big repairs like this, which will put more strain on your budget.

An emergency fund can also be a huge help if you suddenly lose your job or have your hours cut. With plenty of cash on hand, you’ll still be able to make your payments, so you won’t lose the home you worked so hard to buy.

Experts say you should have enough money in your emergency fund to cover at least six months’ worth of living expenses. If you don’t have that much, you’re not ready to buy a house yet. Start setting aside a little each month to build up your nest egg, and wait until it reaches full size to start shopping for a home.

Along with your emergency savings, you need to save up for a down payment – the bigger, the better. The more cash you can put down up front, the less you’ll have to spend on your monthly payments.

Ideally, you want to put down at least 20% of the cost of the house so you won’t have to pay PMI. So, if you want to buy a house that’s worth $200,000, you should aim to have $40,000 for your down payment.

If you’re nowhere close to that amount yet, you need to start funneling all the spare cash you can into your house fund. Start by skimming off some of your paycheck each month – before you even cash it – and put that into the fund. On top of that, save all the extra cash windfalls that come your way: a tax refund, a performance bonus, even the cash back savings from your credit card. Over time, it all adds up.

The higher your credit score is, the better the terms you can get on your mortgage. If your credit is only so-so, boosting it into the good or very good range can help you get a loan you can afford.

There are several ways to improve your credit score:

Businessman handing cheque to other person in the office

As you can see from Lou and Christy, the more debts you have, the harder it is to afford a mortgage. Paying off old debts, such as a student loan or a car loan, leaves more money free for your monthly house payment. It also improves your chances of qualifying for a loan with good terms.

There are several different methods for paying off old debts:

If you manage to pay off all your old debts, you can convert your debt snowball to a savings snowball. Just take the monthly sum you used to pay on your debt and start saving it up for your down payment. You can go from watching your debt shrink to watching your down payment grow month by month.

If you’re on a tight budget, consider programs that can help you get a good deal on a mortgage. Many state governments offer special discounts for first-time homebuyers. You can also get deals based on your income, your job, or where you live. Visit HSH.com to find programs in your state.

There are also programs that can help you afford a down payment. For instance, the National Homebuyers Fund makes grants to low- and middle-income buyers through its Down Payment Assistance Program. Specific states also offer programs to help buyers with their down payments. To find one, do a search for “down payment assistance” with the name of your state.

The bottom line for home buyers is, don’t overstretch yourself. Maybe you could buy that “dream home” if you drained your savings account and squeezed every last penny out of your monthly budget. But if your finances change, that dream could turn into a nightmare.

It makes more sense to leave a bit of breathing room in your budget. That way, if food or fuel prices go up, it won’t stretch your budget to the breaking point. If you run into a major expense, such as replacing your furnace, you’ll have the money to pay for it. And if you lose your job or part of your income, you won’t necessarily lose your home as well.

Finding the right house, like finding the right spouse, takes time. It’s easy to be seduced by good looks and ignore all the drawbacks that go with them. But it’s worth holding out for a home that fits both you and your budget. A house you can afford is a house you can truly live happily ever after with.

Have you ever fallen for an unaffordable home? Or did you hold out for something in your price range?

Categories: Budgeting, Financial Advice, Money Management, Mortgage, Real Estate

Amy Livingston is a freelance writer who can actually answer yes to the question, “And from that you make a living?” She has written about personal finance and shopping strategies for a variety of publications, including ConsumerSearch.com, ShopSmart.com, and the Dollar Stretcher newsletter. She also maintains a personal blog, Ecofrugal Living, on ways to save money and live green at the same time.

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