Think you’re financially ready to buy a house? Before you make appointments with real estate agents and lenders, you should make sure you’ve taken an honest assessment of your income and expenses so you know just how much home you can afford. Doing this will help your agent find the best homes for you within a price range that won’t break the bank.
To help ease this part of the process, we’ve compiled a strategy to reviewing your finances and 8 simple rules of thumb that lenders often use to determine how much they will loan to a buyer.
The costs around buying a house
When you think about the primary cost of buying a house, the down payment is probably the first thing that comes to mind, and for good reason: It’s definitely going to be the heftiest cost associated with the purchase. That said, you might not need the 20% that you’ve heard you need — in fact, the average down payment amount is 6.7%. Of course, the more you put down, the lower your mortgage payments will be, so it’s important to calculate your budget.
But the down payment is only the tip of the iceberg. In addition, you’ll need to budget for these costs:
- The appraisal: Usually between $300 and $1,000
- The inspection: The national average costs $315
- Closing costs: Between 3% and 6% of the home’s purchase price (depending on the market)
And after the deal closes, you’ll need to factor in taxes and homeowner’s insurance. The national average for taxes is $2,279 annually, but this cost could be much higher or lower depending on where you live. As for insurance, you’ll probably shell out around $1,200, but this also can vary greatly based on where you live and depends on a variety of factors — whether or not your home is in a high-crime area, a flood zone, or has a pool, to name a few.
Existing monthly costs
Make a list of all your monthly costs in order to understand what percentage of your income is currently devoted to bills. Here are some common bills you should be sure to include if they apply to you:
- Credit card debt
- Car payments and car insurance
- Student loans or tuition payments
Before we get into the nitty-gritty, be aware that every lender is going to use a different rule (or set of them).
Top real estate agent Joe Bourland in Phoenix (he’s been helping buy and sell homes for 18 years) says that he urges homebuyers to shop around (or use a mortgage broker), because unless you have a credit score of 800 and no debt (which you probably don’t, because you’re human like us), different lenders will use whichever rules they prefer, ultimately giving you several different options to choose from.
Now let’s get to the rules!
The 28% rule
If you’re following this general rule, you shouldn’t spend more than 28% of your gross income (what you take home before taxes) on your mortgage payment (principal and interest).
Example: If your household income is $100,000, then you can afford to spend around $2,300 on your mortgage principal and interest per month; with these numbers, and assuming you have good credit (a score of 680+) and 6.7% for a down payment, then you should be looking at homes priced around $450,000.
The 28% / 36% rule
This rule takes the 28% rule one step further. It states that your total household debt shouldn’t exceed 36% — so after you factor in the 28% for your mortgage principal and interest, you only have 8% remaining for the rest of your bills, including car payments, student loans, and credit cards.
Example: If your family has a monthly income of $5,000, they could budget for a $1,000 monthly mortgage payment (principal and interest) and have $800 remaining for their other bills. Assuming these numbers, you’d want to look for homes priced around $165,000.
While not every lender is the same, the 28% / 36% rule is a common standard for determining your ability to take on a certain size mortgage.
The 32% rule
The 32% rule states that all of your household costs — your mortgage, homeowner’s insurance, private mortgage insurance (if applicable), homeowners association fees, and property taxes — should not exceed 32% of your monthly income.
Example: For a household that brings in $6,000 per month, the total household costs should not exceed $1,920. So, assuming these numbers, if you have $20,950 for a down payment (6.7%), you should look for houses priced around $224,000.
The 40% rule
According to this rule, the total amount of debt you pay each month, including your house, car, credit card, and student loan payments, should not exceed 40% of your monthly income. Lenders will review all of your existing debt, and if that, including your desired home loan, exceeds 40%, you might not get approved. Try to pay down your credit cards or your car loan before you apply for a mortgage.
Example: If your monthly income is $3,000, your total debt should not exceed $1,200.
Bourland noted that this rule is the most common one used by lenders, though it can sometimes fluctuate between 40% and 50%. After the subprime mortgage crisis, lenders are scrutinizing income more closely, so it’s very important to keep your debt as low as possible before applying for a loan.
The 2.5X rule
This rule says to choose a home priced at about 2.5 times your annual household income, but for this rule to work, it really depends on where you live; 2.5 times your household income in California, where the homes are quite expensive, might not go as far as somewhere in the Midwest.
For instance, in Honolulu, homes in 2019 average $661,700, and the average household brings in $65,155 per year — so the average house costs about 10 times the average annual household income. If you’re buying in a higher-priced state, you might need a bit more in savings to account for the disparity between average income and home prices.
Example: If your income (minus taxes) is $180,000, you should be looking at homes priced around $450,000.
The 3X rule
If you spend more than 20% of your monthly income to pay down existing debts, you could potentially consider homes priced up to three times your household’s annual income.
Example: If you make $4,000 per month (or $48,000 per year), but allocate $800 or more to existing debts, you should only look at homes priced at $144,000 or less.
The 4X rule
If you spend less than 20% of your current take-home income on debt, then you could potentially consider a home priced up to four times your household’s annual income.
If you choose to follow the 4X rule, here’s a tip for savings: Have one year’s worth of your salary in the bank. With that amount stored up, you’ll have your 20% down payment ready, as well as 5% leftover for closing costs.
Example: Similar to the above breakdown, if you make $4,000 per month, but your bills are less than $800, then you can consider homes priced up to $192,000.
The 5X rule
The 5X rule applies to those who are entirely debt-free. If that’s you, you can consider homes priced up to 5 times their household income. Of course, you don’t have to take the full loan amount; So even if you are approved at 5 times your income, if you want to keep your monthly payments low, accept a smaller loan.
Example: If you have an income of $100,000, you can consider homes priced up to $500,000.
Don’t forget that your mortgage and existing debts won’t be the only bills you’ll need to pay. Chances are, your new home will be larger than your current space, and therefore, your utility costs will probably go up. You might also need to save for retirement, your kid’s college fund, new furniture, or weekly housekeeping and gardening services.
It’s time to shop
Now that you’ve calculated your budget, you’re ready to hit those open houses! Put on some walking shoes and find yourself an experienced real estate agent to keep your Saturdays and Sundays busy.
Header Image Source: (Austin Distel / Unsplash)