You are ready to buy a home, but have no idea how much you can afford. You know your income, but how much of it should you use for your mortgage? Is there a percentage you should keep for your other bills too?
Before you figure out how much home you should buy, make sure you figure out the answer to this question first. You should know going into the mortgage process how much money you should spend. This way you will be able to stay on budget and not overextend yourself. Sometimes what you can afford on paper and what you want to pay in reality are two different numbers.
Housing Ratio Guidelines
A good rule of thumb is to follow the 28/36 ratio. For now, we’ll focus on the 28%, which is the housing ratio. Try to keep your housing payment at or below 28% of your gross monthly income. This is your income before taxes. Your housing payment should include the principal, interest, real estate taxes, and homeowner’s insurance costs. If you buy a condominium or your development has a homeowner’s association, you’ll need to include those fees as well.
Taking 28% of your gross monthly income will give you an idea of the maximum housing payment you can afford. You can then input that number in a mortgage calculator to determine the total mortgage you should target.
Total Debt Ratio Guidelines
The one thing that might change how much mortgage you can afford is your total debt ratio. In other words, how much other debt do you already have outstanding not related to the home? This will play a role in how much mortgage you can afford. The more debt you have, the less room you’ll have for a mortgage.
In general, your total debt ratio should not exceed 36% of your gross monthly income. In order to figure out how much you can afford after you pay your monthly bills is to take 36% of your gross monthly income and then subtract any outstanding debts from that amount. The figure that is left is what you can afford for a mortgage, as long as it’s less than 28% of your gross monthly income.
Add Your Down Payment
Keep in mind, if you have money to put down on the home, it can increase how much home you can afford. This doesn’t affect how much money you borrow, but rather how much you use to buy the home. For example, if you can afford a $200,000 mortgage, but you have $50,000 to put down on the home, you may be able to buy a $250,000 home.
You should watch where you take your down payment funds from, though. Tapping into retirement funds usually isn’t recommended, even if it’s just a 401K loan. You take away from the fund’s ability to compound interest. Even if you qualify for a penalty free withdrawal because it’s your first home, it’s best if you stick to liquid funds that aren’t set aside for retirement.
Tapping into your savings account or even selling investments in a taxable account don’t have tax consequences or penalties. You won’t face financial consequences for using these funds with the exception of investing the funds in your home that will hopefully appreciate and earn you more in the long run.
Think About What you Want to Pay
No matter what you come up with on paper, actually paying your mortgage can be stressful. Know in your mind how much you are comfortable paying. Consider your current job, its status, and your plans for the future. Do you see you and your spouse going down to one income one day? Do you see yourself going back to school and changing jobs? These factors should play a role in how much you extend yourself financially now.
No one can tell you how much to spend on a mortgage, but you can use these guidelines to give yourself a ballpark figure. Once you know approximately what you might be able to afford, put the figures to the test to see if you’ll be comfortable paying that size mortgage.