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You’re ready to put down roots, build up some equity, and find a place called home. Your bank account looks solid and you’ve been on stable financial footing for awhile now. Buying a house just feels like the natural next step in your life… and that’s an exciting place to be.
Before you set out to find the perfect abode where you’ll one day pop champagne in an empty kitchen, you’ll need to take a hard look at your finances and get familiar with what it means to be a homeowner. The truth is that houses are expensive, long after the closing celebrations fade. Many buyers fail to grasp that. In fact, 63% of millennial buyers have regrets about buying a home because they underestimated just how much it costs.
This guide will take into account all the variables, from mortgage basics to those tricky extra costs like taxes, insurance, and maintenance. From here you’ll be able to create a budget based on smart money management and what professionals across the real estate and finance industries recommend.
Ready to crunch the numbers now? HomeLight’s created a Simple Home Affordability Calculator to help you safely budget and to answer the critical question: How much house can I afford? in a way that won’t lead to a grocery cart full of ramen down the road.
But if the thought of juggling mortgage payments, HOA fees, and maintenance costs (on top of everything else you have to pay for) makes your head spin, you’ll need a little more help. Pick up your pocketbook- let’s make a plan.
Step 1: Tally up those paychecks: How much money comes into your house every month?
To calculate your home shopping budget, you’ll need to start with your income. You should be familiar with two different numbers:
1. Your pre-tax income
Your pre-tax income, also called your “gross income,” is the amount of money you make before deducting for state and federal taxes. People know their pre-tax salary off the top of their head. It’s that high-level number you think of when you say, “I make this much per year.”
Your gross income is also what mortgage companies will use when they calculate how much money they’re willing to lend you. Your pretax income tends to be more stable and measurable, since not everyone knows what deductions and taxes they’ll pay at year’s end.
If you’re buying a home with a partner, you should add your pre-tax incomes together to get your full buying power. Those who work multiple jobs will need to do some math to put together their various income streams.
Keep in mind that nontraditional sources of income such as commissions and bonuses may be treated differently depending on the lender and loan program. In most cases, for example, lenders will require a two-year commission history before they’ll factor that income into your loan qualification.
2. Your take-home pay
Lenders look at your gross income, but you should also know how much money is yours to spend every month since much of what you earn pre-tax is cash you’ll never see. Check out your monthly pay stub to get this number.
Step 2: Figure out your maximum mortgage payment based on your income and current debts
Once you have an idea of your positive cash flow each month, you can figure out how much of it could comfortably go toward a mortgage.
Lenders will look at what’s called your debt-to-income (DTI) ratio, a measure of all your monthly debt payments (think: housing, credit card, car, and student loan payments) as a slice of your gross monthly income, to determine what size loan you qualify for. Per the Qualified Mortgage rule adopted in 2014, most lenders require that your DTI be no higher than 43%.
That means if you had no other debts, most lenders would let you borrow up to 43% of your income. However, many personal finance experts would consider that to be a budget stretch. That’s why you need to have your own budget limits set first.
Depending on how much money you put toward debts each month, you’ll have a little wiggle room to decide whether you’d like to stay on the conservative side or increase your budget for the right home. It’s a personal decision, but the more you spend on housing costs, the less money you’ll have for other expenses, emergencies, and opportunities. Go too far in this direction and you’ll end up “house poor,” aka the person in your friend group who can’t afford to do anything fun.
With that in mind, here are three simple rules to consider for calculating your maximum mortgage payment:
The rule of 30
HomeLight spoke with a variety of personal finance experts, and many of them brought up the rule of 30 as a measure of financial responsibility.
It means that “a person’s home payment should be no more than 30% of their gross income each month,” including taxes and insurance, says Mike Scott, a mortgage professional with more than a decade of experience in the industry.
Financial expert Dave Ramsey believes in a more conservative approach. He recommends that your housing costs shouldn’t exceed 25% of your after-tax income. (He’s also a big advocate of the 15-year mortgage for those who can swing it).
Refer to the after-tax income you calculated above, and follow this rule if you like the freedom of having plenty of disposable income to play around with every month.
Dinner out on the town? You’ll be there, and be able to pay your mortgage to boot!
To illustrate, let’s suppose you and your partner bring in the average American pre-tax household income of $60,000, or $5,000 per month. You’ve decided to follow the rule of 30 recommended by personal finance experts and cap your housing costs at 30% of your pre-tax income. You’re aware that your total debts won’t be able to exceed 43%.
We’ll call it the 30/43 plan:
Calculation 1: mortgage payment
$5,000 (income) * .3 (maximum housing costs) = $1,500
Calculation 2: debt
$5,000 (income) * .43 (maximum debt) = $2,150
Using this method, your house payment shouldn’t exceed $1,500 a month, and your total debts shouldn’t exceed $2,150. If you already pay $350 a month toward your car and $400 for student loans, you’d need to subtract that from your debt maximum, like so:
$2,150 (the amount you can pay toward debts every month, including housing payments)
-$350 (car payment)
-$400 (student loans)
$1,400 maximum mortgage payment
To keep your DTI in check, you could spend a total of $1,400 on:
- Mortgage principal and interest
- Homeowners insurance
- Private mortgage insurance (if applicable)
- HOA fees (if applicable)
Finally, if you have no debts or your debts are less than $650 per month ($2,150- $1,500) then your mortgage and associated housing costs budget remains at $1,500 per the rule of 30.
But you may be wondering: what are these extra costs that come with your mortgage? Let’s break those down before we dive into interest rates, mortgage terms, and down payments.
When you get a mortgage, you’ll likely bundle property taxes into your monthly payments as part of your escrow account. Property taxes vary widely across the country, but your county’s appraisal office should be able to pull the last three years of tax records for the property you’re interested in. These records will tell you what the property was assessed for, and what taxes were associated with it.
From there, you should be able to find a trend. Has value remained steady over the past three years or grown by a certain percent year over year? This can give you a general idea of what monthly tax payments will amount to not just now but in the future.
If you opt out of escrow and end up paying taxes in lump sums, you should save enough money every month to prepare for the payment. Property taxes are typically due twice a year, and the average American pays $1,518 in property taxes each year. Don’t get slapped with a $750 dollar bill you haven’t planned for.
Homeowners insurance rates, much like taxes, vary greatly based on location. In 2018, the national average for home insurance was $1,083 annually. You can take a look at average premiums per state for a closer ballpark figure.
Several factors can raise the cost of your home insurance, including:
- Wood-burning stoves
While its estimated that over one-third of U.S. homes use wood-burning stoves as a primary heat source, they’re also responsible for 36% of home fires.
- Marital status
Sorry singles, you might pay more for your home insurance. Married couples file fewer claims on average, and insurance companies view them as less risky clients.
- Age of home
If your home is older, it’s more likely to have a higher premium. That’s due to degrading materials or features that would be more costly to replace.
- Swimming pool or other water features
Pools and hot tubs are charmingly considered “attractive nuisances” in the insurance world. Depending on how your pool is classified, it could fall under your home insurance and lead to higher premiums due to its potential for hazard.
- Roof condition
Similar to the age of the home, an older roof will likely fetch a higher premium.
- Proximity to fire department
Your distance from the fire department and proximity to a water source can have a slight bearing on your insurance—the closer you are, the lower the cost.
- Proximity to body of water
If you’re close to the shore or located near a flood zone, you might be required to include flood insurance on your home, which adds to your monthly payment.
When you browse your favorite real estate search engine, don’t forget to factor in the costs of taxes and insurance. Some sites will advertise a low monthly mortgage payment but “fail to include common additional fees,” says CPA, personal finance expert, and virtual CFO of financial site Dollar Sprout Ben Watson.
Step 3: Go big on the down payment, but don’t stretch your means
So far we’ve covered how to calculate how much you can afford to put toward a mortgage payment and its associated costs every month. But the down payment, a sizable chunk of change you put toward your house at the time of closing, separates the renters from the owners. Trouble is… the down payment is often the no. 1 obstacle to achieving homeownership.
Not everyone has the funds to make it happen, but if your savings allow for a 20% down payment on your home, you will likely be able to avoid paying private mortgage insurance on a conventional loan.
What is private mortgage insurance?
Mortgage insurance protects the lender in the event that you default on your home (but it does not protect you from foreclosure). If you put less than 20% and select a conventional loan program, you will likely have to obtain Private Mortgage Insurance, or PMI, through your lender. You will likely have to continue paying for PMI until your mortgage balance is less than 80% of the current market value of your home.
On average, though, PMI typically costs between 0.5% and 1% of your entire loan annually. On the average $279,000 home, you could spend just under $250 each month on PMI. “This insurance isn’t something you can shop around for,” Watson explains. “It’s determined by the lending company and disclosed to you during the closing process.”
20% down isn’t your only option
However, you don’t need a 20% down payment to buy a house. In fact, the national median down payment on a home in 2018 was 13%. To put it in perspective, down payments truly run the gamut: “Gosh, the other day I saw a 3% down conventional loan,” says first-time homebuyer specialist and top Fort Worth, Texas area real estate agent Jordan Davis.
The more you can put down, however, the less you’ll pay in interest over time (whatever you don’t put down, you have to finance through the bank). Plus, a higher down payment reduces your monthly mortgage bill and your mortgage rate, saving you more money over time.
However—plot twist!—as much as a higher down payment is great, you also don’t want to empty your bank account to afford a higher down payment. You’ll need emergency funds on hand for maintenance and surprise repairs.
As a buyer, you can increase your down payment percentage and still keep your budget in check by purchasing a lower-priced home. Your monthly mortgage payments will also go up or down depending on which mortgage term you select (15-year terms will save you on interest, but cost more every month, lowering your purchasing power).
Let’s look at some examples. Back to our average buyer who brings in $5,000 a month, and can afford a $1,500 mortgage payment, including principal, interest, taxes, insurance, and PMI where necessary.
These would be a few options at their disposal, depending on how much money they had on reserve:
- $183,400 home with a 10% down payment ($18,340)
- $214,000 home with a 20% down payment ($42,800)
- $239,200 home with a 30% down payment ($71,760)
- $272,200 home with a 40% down payment ($108,880)
- $248,075 home with a 10% down payment ($24,808)
- $292,400 home with a 20% down payment ($58,480)
- $325,500 home with a 30% down payment ($97,650)
- $366,800 home with a 40% down payment ($146,720)
Don’t forget about closing costs
Once you know your price range, you can budget for your closing costs, which is another hefty chunk of change due at the time of sale. Buyer closing costs, which often include fees for your loan application and mortgage origination, transfer taxes, title search, and inspections and typically clock in between 2%- 5% of a home’s final sale price. On a $200,000 home, that’s an additional $4,000-$10,000 out of pocket.
Some buyers choose to pay Discount Points to certain lenders at closing in an effort to buy down their interest rate. This is a trade-off, though—you’ll have to weigh the cost of paying more upfront versus your interest savings over time, which will be more advantageous if you plan to stay in the house for a longer period.
Finally, closing costs vary among lenders. Shop around and compare fees, and don’t hesitate to let a lender know that someone else has offered to give you a better deal. They might negotiate with you.
Step 4: Leave room in the budget for maintenance and emergency expenses
No matter the condition of your home, you’ll want to budget for maintenance and upgrades on a monthly basis. According to home maintenance experts at HomeAdvisor, the average homeowner spent $7,560 on home improvement projects in 2018.
First-time homeowners will be surprised by how much owning a house costs. “I commonly advise people put aside $150 to $200 a month or more to cover repairing or replacing fixtures such as washer/dryers, HVAC units, or furnaces,” suggests Watson. From small cracks in walls, to old appliances that kick the bucket, it can feel like the repairs are endless.
You can plan and budget for future renovations, but emergency repairs are bound to arise. One in three owners reported paying on average $1,206 last year for an unexpected project. Two out of three homeowners in the same study reported having no emergency budget at all.
“I would suggest having about three months of savings that would cover your mortgage, as well as utilities and taxes,” Davis says. To figure out a month of savings, take the average of your last six months of spending. Then try to save triple that amount. This should be enough to take care of living expenses if something unexpected should arise.
Finally, if the idea of an HVAC breakdown keeps you up at night, a home warranty might be the relief you need. “After you save for a down payment and pay closing costs, you’re going to be pretty cash poor going forward,” Davis says. “Having a home warranty on your property can cover you in case anything out of the norm does happen.”
The average monthly cost of a home warranty is between $25-$50 and plans cover some or all of the following:
- Garbage Disposal
- Air Conditioner
- Heating System
- Water Heater
Depending on the age and condition of your home appliances, this monthly payment could offer peace of mind. In some cases you may be able to ask the seller of the home to cover the costs of the home warranty at closing for your first year or two of ownership.
However, be sure to weigh the monthly cost of the warranty versus what you could do with that money if you saved it for repairs, and check into the company’s policies. Home warranty companies receive a lot of customer complaints over disagreements on what the warranty covered and the cost of repairs.
Step 5: Get the best interest rate you can and pick your mortgage term
Don’t start worrying about exact interest rates until you find a place you love, advises Davis. Then start speed dating mortgage lenders to get at least three different quotes. Each quote will likely include different closing costs as well.
“Some will pad the interest rate to give you no closing costs,” said Davis. “Some people will pad the closing cost to give you a lower interest rate.” Not all quotes will look the same, so the more your shop around, the more likely you are to find a lender that fits your needs.
Don’t be afraid to source quotes from a variety of different sized lenders as well, says Watson who notes:
“Sometimes the local bank in your area will have special discounts for first-time homebuyers or young families moving into certain neighborhoods.”
Typically, a larger down payment will lead to a lower interest rate, since your loan is smaller and less of a risk to take on. The bigger your down payment, the less you’ll borrow overall, meaning you’ll save money in the long term. For a closer look at how your down payment influences interest rate, check out the Consumer Financial Protection Bureau’s interest rate calculator.
Your credit or FICO, score, on the other hand, can have a much larger impact on your interest rate. Here’s how much you’d pay in interest on a median-priced home based on your credit score:*
|FICO Score||APR||Monthly Payment||Total Interest Paid|
You’ll also have to consider if you want a 30-year or 15-year mortgage. Both come with their own pros and cons, and depending on your financial burden, one might make more sense than the other.
- Typically carry a lower interest rate, so you’ll pay less interest overall.
- Have a higher monthly payment, since you’re paying more of the principal per month.
- Are harder loans to get approved.
- Mean less wiggle room for savings, emergencies, or job instability.
- Come with a higher interest rate, as they can be perceived as riskier for banks.
- Have a lower monthly payment than a 15-year loan.
- Mean more financial freedom for saving each month.
Work with your real estate agent and mortgage lender to decide what loan length works best for your financial goals.
Step 6: Follow these pro tips to make the most of your mortgage
Choosing the right mortgage is individual to each homebuyer… Don’t forget to keep these tips in mind as you calculate how much mortgage you can afford.
- Pay off debt before you take on more
Mike Scott the mortgage pro suggests that buyers shouldn’t borrow more money until they’ve got their existing debts under control. “In a high debt-to-income ratio situation, you may be better off swallowing your pride, moving back in with family, and focusing on paying off those debts first.”
- Play it safe with the single-income challenge
When you shop for a house you’ll have the option to factor in both you and your partner’s income. But Watson challenges budget-conscious buyers to shop with a single income, instead of combined.“That way, if one of you loses a job or stops working to have kids, you aren’t facing a crisis,” says Watson.
- Some expenses save you elsewhere.
In some cases you can responsibly spend more than 30% of pretax income on housing payments. Davis gives the example of a case where homeowners association (HOA) fees push you over the mark.If the association takes care of things like lawn and pool maintenance, or its state of the art gym will eliminate your need for a monthly membership, the additional payment could make sense.“I think that’s where it can get tricky,” says Davis. “When there’s HOA dues, it can cost buyers more than they were planning on, but when you really consider what they take care of and pay for, it can be worth it for some.”
Step 7: Set your budget and tweak it to your liking
After all the calculations, hypotheticals, and recommendations let’s drill this down to see exactly how much home a person might be able to afford using our running example:
- You make $60,000 annually, or $5,000 each month, pre-tax.
- If you’re following the rule of 30/43, you’ll spend no more than $1,500 (30% of $5,000) a month on home payments. This includes principal, interest, taxes, insurance, and PMI if you put down less than 20%.
- Based on national averages, as well as the average down payment (13%), on a 30-year mortgage with a 4.3% interest rate you could theoretically afford a home for $255,000 by paying a $33,150 down payment and putting $1,498 toward your housing costs monthly. You’ll pay at least around $5,100 in closing costs. This does not include savings for maintenance and upkeep.
- If you want to be more conservative, you could cap your home search to $200,000. Your down payment would go a lot further, meaning you might not need PMI and could go for that 20% down. At $200,000, you’d be paying closer to $1,000 a month, leaving nearly $500 to spare for maintenance and emergencies.
A word of caution: You’ll be tempted by bidding wars and homes out of your price range
Houses are notorious budget busters. A study in Australia showed that 44% of homebuyers paid more for a house because they “really liked it.” What’s more, one-third of buyers said they spent more than they planned to on a house during the first quarter of 2019, according to research from CoreLogic. In the hot seller’s market of 2018, those buyers who overspent went $16,510 over budget on average to compete for houses.
The temptation is real. However, life is a series of trade-offs. The more your housing costs take over your budget, the less money you’ll have to spend on dinners out, vacations, and furniture to fill your empty home. Keep your eyes open to the hidden costs of homeownership and get to know your own finances to set financial boundaries that will stick.
Then you can go nuts and obsess over new listings from your amazing real estate agent guilt-free. Happy shopping!
*This information is for educational purposes only and not intended to illustrate available APRs or mortgage-related marketing under the Truth-in-Lending Act Section 1026.24.