What you can buy and what you can afford are two totally different things. Therefore, it’s best to figure out how much home you can afford before house shopping.
Together, we’ll learn how to determine how much mortgage you can afford and the key factors in calculating home affordability. Armed with this knowledge, you can responsibly achieve your homeownership dreams.
The 28/36 home affordability rule of thumb
One of the easiest ways to calculate your homebuying budget is with the 28/36 rule of thumb. The 28/36 rule is used to calculate how much debt a household can safely take on based on their income and debts.
According to the 28/36 rule, a household should spend no more than 28% of its gross monthly income on total housing expenses and no more than 36% on total debt service. While different lenders use varying criteria to determine whether to approve credit applications, the 28/36 rule is a helpful baseline in determining your financial health.
For example, if you make $4,000 a month, your monthly mortgage payment should be no higher than $1,120, and your monthly debt payments should be no higher than $1,440, which would be 28% and 36% of your gross monthly income, respectively.
Factors affecting home affordability
While your housing budget will be determined partly by the terms of your mortgage, your personal financial situation will play a much larger role. The following factors will help you calculate how much house you can afford:
- Monthly income: If you stick to spending no more than 28% of your gross monthly income on your mortgage payment, you should have plenty of room in your budget for savings and investment purposes.
- Monthly debts: You should spend no more than 36% of your gross monthly income on debt obligations, such as car payments, credit card payments, and student loans.
- Cash reserves: Your cash reserves refer to the money you have set aside for future use, whether it be your savings, investments, or other sources. In other words, this is the amount of money you have available to cover your down payment and closing costs. If you can afford to put a sizeable down payment on a property, you may qualify for lower interest rates and avoid additional costs, such as mortgage insurance.
- Credit score: Your credit score plays a critical role in determining whether you qualify for a mortgage, and what interest rate you’ll be offered. The higher your score, the lower the risk you pose to lenders, and the likelier it is you’ll be offered a more attractive interest rate. In general, the lower the interest rate, the lower your monthly mortgage payment will be. Just a 0.5% difference in your interest rate could cost or save you thousands over the life of the loan.
- Additional costs: Along with the aforementioned housing affordability factors, you’ll also need to consider extra costs such as property taxes, homeowners insurance, private mortgage insurance (PMI), and closing costs.
The bottom line
Purchasing a home is likely to be one of the biggest financial decisions you’ll make in your lifetime. Consequently, it’s critical to be realistic about your financial situation and what you can afford, especially in today’s volatile housing market.
A vital step in figuring out how much home you can afford is getting pre-approved. A pre-approval letter can save you valuable time by identifying how much you can afford, so you can shop for homes within your budget. Once you’ve done that, it’s time to go shopping for your dream home!
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