Buying a house brings along a full range of emotions, from nervous excitement to sheer dread over the financial commitment you’re about to undertake. It can be easy to simply put a full price offer on the first house you fall in love with, but it’s not necessarily the best decision you can make. Just as the type of home you purchase affects the way you live your life, so too does the amount of money you spend. That monthly mortgage payment is probably your most important bill to pay each month, and if it’s too high, you might have trouble meeting your other financial obligations. Or you might be ok paying for the necessities but may not have the wiggle room for fun purchases you typically enjoy. Before you start binging on Zillow searches, take a few moments to thoughtfully consider how much house you can actually afford.
Evaluate Your Existing Budget
When it comes time to apply for a mortgage, it’s vital that you remember to advocate for yourself. Loan officers use strict underwriting guidelines to approve loan amounts, but even with those in place, you don’t necessarily want to borrow the full amount you’re eligible for. Be sure to ask questions even after you’ve gotten an initial amount pre-approved. Where are interest rates for your credit category right now? What other types of fees and charges can you expect to pay? Don’t forget about taxes and homeowner’s insurance — those expenses are included in your monthly mortgage amount as well. A good lender breaks down all of these associated costs so you can get a holistic idea of what a certain price point looks like in terms of actual payments. Then you can play around with a mortgage calculator to find some numbers that make you feel comfortable.
So what is comfortable when buying a house? It really depends on two things: your income and your current level of debt. Most lenders allow for a total debt-to-income ratio of 43%. That means only 43% of your monthly pre-tax income may be used for recurring debt payments, including credit cards minimums, student loans, car loans, and your new mortgage payment. If you have a lot of other types of debt, you might not be able to afford a large home loan. But even if you don’t have much debt, it’s still not prudent to spend 43% of your monthly income on your mortgage. After all, you don’t want to max out your ability to borrow money in case you need another type of loan in the future. Some conservative estimates recommend budgeting no more than 25% of your after-tax income for your mortgage payment.
Determine Your Upfront Expenses
It’s easy to get a loan without using much cash for a down payment, but you almost always need some type of funds upfront. FHA loans allow for as little as a 3.5% down payment. That means if you buy a $200,000 house, you’d need a down payment of $7,000. USDA and VA loans typically come with 0% down payments so you don’t need any extra cash for this purpose. However, the downside is that any mortgage with a down payment of less than 20% is subject to mortgage insurance. This is an annual expense you’re charged that protects the lender against default since you don’t have much equity in the home. The annual rate depends on your loan type and is divided up amongst your monthly payments each year. It can easily add $100 or more to your mortgage payment.
In addition to the monthly charge, most loan programs charge a one-time mortgage insurance fee on top of your other closing costs. For FHA loans, you’ll be charged 1.75% of your loan amount. If you have a mortgage of $193,000 (assuming you put down 3.5%) your mortgage insurance premium at closing would cost $3,377.50. That’s on top of your other closing costs, like fees for the home appraisal, attorneys, escrow, homeowner’s insurance, and others. Most buyers pay between 2% and 5% of their new home’s purchase price. That could be as much as $10,000 for a $200,000 home. You can try to negotiate closing costs as part of the seller’s concessions but this isn’t always possible, especially in competitive real estate markets. You may be able to finance them as part of your mortgage, but that again increases your monthly payments.
Think About the Future
While it’s important to fully consider your current finances when deciding how much to spend on a house, you should also think about your future. You might be in a steady job now, but if there’s anything 2008 taught us, it’s that nothing is ever certain (except, of course, death and taxes). Do a quick mental audit and determine how prepared you are for an unexpected job loss. Do you have enough in your savings to pay your mortgage and other necessary expenses? Most financial experts recommend having at least three to six months of income set aside to prepare yourself for this type of situation. Whether you lose a job, have a sudden injury, or become the caretaker of a relative, you need a plan so you don’t risk losing your home to foreclosure in an emergency.
Another consideration is your retirement, even if it’s decades away. You may be betting that you can sell your home and downsize when you’re ready, but there’s no way to predict real estate trends. The best way to a successful retirement is limiting your necessary expenses so that you can afford to live on a smaller income. If you’re confident in your current retirement savings, then you might be able to afford your mortgage when the time comes. Or maybe you’re young enough where you expect to have that 30-year mortgage paid off before you’re ready to retire. But life throws so many curveballs, it’s impossible to really know what your finances will be like in your 60s. Of course, you don’t want to live your entire life in fear, but always have multiple game plans in mind, rather than relying on one “sure thing.”
How to Afford a More Expensive Home
After researching and performing your due diligence, you might still find yourself ready to buy a more expensive home. Maybe you need the space for your growing family or maybe you live in a city with a high cost of living. After all, in many places, the cost of monthly rent is just as expensive — or even more so — than an actual mortgage payment. There are several ways you can bring down that monthly payment. Start by trying to qualify for a better interest rate. You can do this by raising your credit score, reducing your debt, or increasing your earnings. It’s no secret that your credit history greatly affects your ability to borrow, and both your debt and wages impact the ever-important debt-to-income ratio. Most of these steps can’t be checked off in a weekend but can put you on a better path to financial stability.
You also have the option to save more money. Having extra cash on hand allows you to make a higher down payment. That, in turn, lowers your loan amount, reduces your monthly payment, and also gives you more equity in the home. If you can afford a down payment of a full 20%, you get the added bonus of saving on mortgage insurance. With even more cash, you can pay all of your closing costs upfront so you don’t have to worry about adding that amount (plus the corresponding interest) to your monthly payment. Again, this is easier said than done, but it might be worth taking on a temporary part-time job to get the home that’s right for you.
Refinancing Your Mortgage Down the Road
The good news is that once you have a mortgage, your loan terms don’t have to stay the same forever. You have the ability to refinance, which entails paying off your mortgage with a new loan with different terms. Refinances have been popular recently because of historically low interest rates. However, the Federal Reserve has recently started implementing rate hikes, which are expected to continue gradually. While you shouldn’t count on lower interest rates for a future refinance, this process can help you in other ways. If you have equity in your home (typically 20% or more), you can do a cash-out refinance or a home equity line of credit (HELOC). Both allow you to access cash based on your home appraising for a certain value. You then either have a higher mortgage with the refinance, or repay the HELOC like you would a credit card.
The downside to a mortgage refinance is that it comes with all of the costs associated with a new home loan. For example, you’ll have to pay for the appraisal of your home, usually amounting to a few hundred dollars. There will also be closing costs involved, which can either be paid for upfront or rolled into the new mortgage. Because of these new expenses, you’ll need to do some math to figure out if the new loan makes financial sense for you. This, of course, depends on your goals, whether it’s lowering your monthly payment, getting out of your mortgage insurance, or cashing out on your equity. A mortgage loan officer can help you with these calculations, but it’s also smart to crunch the numbers on different situations on your own. After all, you have no better advocate than yourself!
Buying a house is expensive, no matter how you end up financing it. But it’s also an extremely personal situation that greatly influences how you live your life every day. The best way to figure out how much house you can afford is to find a balance between your heart and your head. Obviously, you don’t want to be house poor because of a mortgage, but you also want to feel safe, secure, and happy in your home. It’s an investment in yourself as much as it is an investment in real estate.
If you’re feeling overwhelmed with property listings, mortgage calculators, and loan applications, don’t be afraid to take a breather. Talk to a friend or family member who has bought a home in the past and ask for tips from their experiences. They don’t have to dive into personal numbers, but they can give you an idea of things to be aware of throughout your own home buying process. When you’re ready, you can jump back into the process and get ready to afford the home of your dreams.