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How Much House Can You Really Afford?

How Much House Can You Really Afford

Buying your first home can be an incredibly exciting, yet scary process. The thought of home-ownership makes some people break out in hives, not due to the responsibility of taking care of their very own place, but because of the process of obtaining a mortgage. Lenders today will look at your credit, income, down payment, and other factors before ultimately approving your loan. However prior to a final approval, you will receive what is commonly known as a pre-approval.

Related: The Hottest Housing Markets in America

In today’s real estate market, the demand for affordable single family housing far exceeds the supply in America’s hottest markets. Many new home buyers find themselves shopping for residences that in some cases they shouldn’t be looking at, however due to the numbers their loan officer has crunched, they believe they can afford it. So how much house can you really afford?

First, let’s talk basics.

The general rule of thumb is to take your current annual salary, and multiply that by 2.5. That number should be the purchase price ballpark for your first home (maximum). In our example, if you are earning $75,000 gross annually, you would like to stay in the range of $187,500 for a first home. I know there are some right now reading this article saying “I live in NY/LA/DC” and I can’t buy a room for that. You are likely right. That said, numbers don’t discriminate based on geography. Someone making $75,000 in Austin, TX or Atlanta, GA will be afforded the same housing allowance as someone in Manhattan. If you feel you are priced out of your current market, it may potentially make sense to rent vs. own until you can relocate.

Once you have a general idea of the home prices you should look at, it’s time to figure out if you can really afford to purchase right now. If you are one of the thousands currently carrying consumer debt via credit cards or auto loans, consider paying those balances down/off first. We won’t tell you to delay your dream of home-ownership until you are completely debt-free, however if you are able to do so, you will end up in a considerably better position financially.

Determining your DTI

When looking to purchase a home, the term debt to income ratio (DTI) will surface at some point. Your debt to income ratio is determined by adding your housing related costs plus all recurring monthly debt, all divided by your gross income. As a reminder, recurring monthly debt includes all payments for student loans, auto loans, credit card debt, installment loans, alimony, or child support obligations, and any delinquent tax debt on repayment.

Using the gross annual income from our earlier example, someone making $75,000 a year will gross $6,250 a month. If you were shopping for a home with a purchase price of $185,000 at 3.75%, assuming roughly $1,000 for homeowners insurance premiums and $2,400 for property taxes, your potential monthly payment would be $1,076 with a down payment of 20%. If you did not have the reserves to put that hefty of a sum as yet, you may be considering a government backed loan such as FHA, in which only 3% (5,550 in this example) is needed. You may see a slightly higher interest rate, however this brings your estimated payment to $1,422.

Now, let’s determine your DTI. Using assumptive averages, if you had a current car payment of $350, student loan payments that came to $250 per month, and credit card debt that had a monthly payment of $155,  your DTI equation would look something like this:

$1422 + 350 + 250 + 155 / $6250 = 34.8% DTI

In our example, your DTI of 34.8% is within range for approval for an FHA loan. We caution there are many other compensating factors that will come into play regarding a loan approval, and suggest you schedule meetings with 3-4 lenders before deciding on one to use. You need to feel a sense of comfort and trust with your lender, and ensure they have your best interest in mind. Just because the bank says you are prequalified for a $500,000 home does not mean you should be purchasing a property with a potential payment of that size.

 

Home Affordability Calculator via Zillow

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