How Much House Can I Afford?

Buying a house is an exciting life milestone and, for many, a big step toward building wealth.

But, while a home can be a good investment since homeowners typically have higher net worths than renters, buying a house that's too expensive causes all kinds of financial problems.

The last thing you want is to be house poor, or have housing costs that are too high for your income. But it can often be difficult to determine exactly how much money is too much to spend on your home.

The good news is, this guide will help you figure out exactly how much house you can afford.

Don't let the bank or realtor decide for you

One of the most common mistakes people make is buying as much house as their bank allows or letting a real estate agent push them into buying a house at the upper end of their price range.

It's your money and financial future at stake. The bank may allow you to buy a home you can technically afford -- but this lender doesn't know your other financial goals or how the purchase will impact the big picture.

And a realtor who wants a bigger commission may not see the harm in showing you a house you'll love that's just a little above what you want to spend -- but you're the one that will be stuck with the bills for decades.

While you need to know what rules lenders apply when deciding how large of a mortgage to approve, it's also a good idea to evaluate your own financial situation and make a decision about how much you can responsibly spend before you even meet with a mortgage broker.

Otherwise, it could be too tempting to take the largest loan you're allowed, especially if a realtor has shown you a house that's perfect but in a high price range.

How to decide how much house you can afford

When people decide how much house they can afford, they often focus only on whether monthly payments are within their budget. But this isn't the only factor that matters.

There are actually three things to think about when deciding how much to spend on purchasing a home:

• Up-front costs: These are the initial costs you'll have to pay to buy the home and settle in.
• Total ongoing housing costs: These are the costs you'll pay year after year.
• General financial readiness: You may be able to technically afford a house if you have enough money to cover up-front and ongoing costs. However, if this would put you at risk of going into debt or make accomplishing other goals impossible, you can't actually afford the home.

How much are up-front costs?

Before you get into determining if you can afford monthly payments, figure out how much money you have available now for up-front costs of a home purchase. These include:

• A down payment: You should have a down payment equal to 20% of your home's value. This means that to afford a $300,000 house, you'd need $60,000.
• Closing costs: Typically, you'll pay around 3% to 5% of a home's value in closing costs. On a $300,000 home, you'd need $9,000 to $15,000. Closing costs can include appraisal fees, prorated property taxes, transfer taxes, title insurance, and more.
• Moving expenses: If you hire professional movers, expect to pay around $1,000 or more, even for a local move. Moving yourself can also be expensive if you rent a truck and buy boxes and packing materials.
• Furniture: You don't want to live in an empty home, so if you're moving from a furnished apartment, parent's house, or college dorm, you'll need the essentials such as a bed, couch, and table to eat at.
• Utility hookups: Getting connected to utilities such as sewer, water, and electric can cost several hundred dollars due to required deposits.

Even with no moving expenses, no need to buy furniture, and no utility deposits, you'd need to have a minimum of around $69,000 in savings for a $300,000 home -- depending on closing costs.

The amount of your savings is a good starting point for determining how much house you could afford. If you have just $20,000 saved for a down payment, the maximum-priced home you could comfortably afford would be a $100,000 home -- assuming you had more money saved for these other up-front expenses.

Is a large down payment really necessary?

Coming up with a down payment is one of the biggest struggles for many home buyers. And technically, you don't need a 20% down payment.

You can qualify for FHA loans with a down payment as low as 3.5%, and many conventional mortgage lenders also allow you to put down less than the 20% recommended amount.

But, if you don't put down at least 20%, you'll typically have to pay private mortgage insurance (PMI) monthly. PMI typically costs around 0.5% to 1% of the total loan value. It's insurance that protects the lender in case you get foreclosed on and the lender doesn't recoup all costs. It doesn't benefit you at all, but you're the one stuck paying.

You're also at serious risk of becoming trapped in your home if you put too low a down payment.

If you need to move, your home is worth exactly what you paid for it, and you put down either no down payment or a very low down payment, you could still have serious financial problems.

You'd likely need to pay realtor commissions equal to around 6% of the home's value for selling your home -- plus a few thousand dollars for closing costs. This is money you might not have, especially if you're moving because the home's become unaffordable due to a job loss.

If property values fall, you're in even bigger trouble if you had a low down payment. The home could be worth much less than what you owe, which could make it impossible to sell without bringing thousands of dollars in cash to the table or ruining your credit by getting the lender to agree to a short sale.

The risks are very substantial. So, if you can't afford to make a 20% down payment, think seriously about whether you can actually afford a home.

How much of your income should go to ongoing housing costs?

Next, it's time to figure out how much you can afford to pay each month for ongoing costs.

Financial experts generally recommend you spend no more than 30% of income on housing. If you exceed this percentage, the government classifies this is a housing-cost burden.

Apply the 30% rule when deciding how much income you can devote each month toward paying your mortgage, property taxes, and insurance. If you make $3,000 monthly, for example, you could afford to spend no more than $900.

Unfortunately, around 39 million American households are burdened with housing costs exceeding 30% of their pay. This is a big problem. If your total housing expenditures take up so much of your paycheck, you'll have a lot of trouble fulfilling any other financial goals.

If you want to save the recommended 20% of income -- and you should -- you'd have less than 50% of your money left over for every other expense if you exceed this 30% ratio.

What are your total ongoing housing costs?

You can use a mortgage calculator to find out how big of a mortgage you could get and still keep your payments below 30% of monthly income. This lets you know the maximum mortgage you can afford, which in turn determines how much house you can buy.

You also need to look beyond just the monthly check you'll write to a mortgage lender because there are many other costs associated with owning and maintaining a home. These include:

• Property taxes and insurance: Bigger homes that are worth more money cost more to insure, and property taxes are higher.
• Utilities: A bigger house means more electricity, a larger septic system, or other added utility costs.
• Maintenance and repairs: You generally should plan to budget around 1% of your home's value for maintenance and repairs per year.
• Homeowners' association dues: If you live in a neighborhood with an HOA or a condo with association fees, you'll need to budget for these. Find out the rules for when the dues can rise and circumstances under which a "special assessment" could be made, as this could mean a really big bill.

Ask your realtor to obtain information about all of these costs for any home you're looking at so you can see if you can afford it.

For example, if you bought a $300,000 home, at 4% interest, you should have a $240,000 mortgage -- assuming a 20% down payment -- and your monthly payment would be $1,146.

If you had an additional $500 per month in other essential costs such as taxes, insurance, and HOA dues, your total payments would be $1,646. The home would be unaffordable unless you had a monthly income of $5,486.

If total costs are above 30% of income for any house you're considering, you may want to find a cheaper home or wait until income rises.

Interest rates matter

Interest rates matter a lot when determining how much you can afford because the higher the interest rates, the more expensive the monthly payments and total cost of the home.

If you took out a $520,000 mortgage at 4.5%, your monthly payment would be $2,635 and your costs over 30 years of paying on the loan would be $948,515. But, if rates were much lower -- around 3.25% -- you could take out a $600,000 mortgage, have a smaller monthly payment of just $2,611 per month, and would pay a total of $940,046 over 30 years.

You'd be able to afford to borrow much more at the lower rate -- although, you'd need to consider whether borrowing more to buy a more expensive house would mean paying higher taxes. And, you'd need to make sure you have a large enough down payment to afford a costlier home.

Because interest rates play such a big role in the cost of buying a home, it's important to improve your credit as much as possible before purchasing. A good credit score will help you to get the most competitive rates so buying a home is more affordable.

Are you financially ready for a house?

If you've got a down payment saved up and can afford monthly payments for homes in your area, you may think you're ready to buy. But it's a good idea to get your financial ducks in a row before purchasing.

This means making sure you have an emergency fund -- ideally with three to six months of living expenses in it.

Owning a home can be very expensive because surprise repairs are common. The consequences of being unable to pay your mortgage because of a setback are also dire, as you could lose the house and damage your credit.

Having an emergency fund allows you to be prepared for surprises without debt, and reduces the chance a health issue or job loss could lead to foreclosure.

Because the risks are high of wiping out your savings to buy a home, seriously consider waiting until you have enough money saved for emergencies -- separate from your down payment -- before you make an offer on a home.

What about your other goals?

It's easy to get caught up in whether the down payment and ongoing costs are affordable -- but you also need to look at the opportunity cost.

While it's classified as affordable to devote a full 30% of your income to your home, if you want to retire early or put five kids through college, this may be too large a portion of your income to spend.

Create a sample budget, factoring in housing costs and other expenditures, to see how much money you'd have left over after paying for houses valued at different prices.

If you'd scrimp to make payments on a $300,000 house and be unable to save for early retirement, you may only be able to afford a $200,000 house no matter what the "experts" say.

Only you know what your financial goals are -- which is why it's important to decide for yourself how much house you can afford instead of just borrowing what a lender tells you that you can.

How lenders decide what you can afford

When lenders decide if you can qualify for a home loan -- and determine what amount to lend you -- they look primarily at debt-to-income ratios. That's because they care only about the likelihood you'll be able to repay the loan.

Your debt-to-income ratio (DTI) is the percentage of your gross monthly income that will go toward paying debts, as well as paying your mortgage in other housing costs.

Lenders don't consider all costs, because they don't factor in things like utilities and maintenance -- but DTI does provide insight into how much of your income will be eaten up by required expenditures.

According to the Consumer Financial Protection Bureau, you typically won't be able to qualify for a standard mortgage if your debt-to-income ratio exceeds 43%. However, individual lenders have more or less stringent qualifying requirements, and, in fact, a 36% debt-to-income ratio is typically considered ideal.

Calculating your debt-to-income ratio

You can calculate your debt-to-income ratio by adding up all the monthly payments you make on all debts and housing costs -- including your mortgage, car loans, student loans, credit card debt payments, taxes and insurance, and other required monthly obligations.

Then, divide this number by gross monthly income, which is pre-tax income before deductions.

If you make $4,000 monthly and your total housing costs and debt payments would be $2,000, you'd have a 50% debt-to-income ratio and probably wouldn't qualify for a mortgage.

This means, if you have too much debt, you won't be able to afford a very expensive house -- or any house at all -- since your total payments including housing costs would make your debt-to-income ratio too high.

Likewise, if you live in a place where housing is very expensive, monthly mortgage and property tax payments alone might be enough to push your debt too high to meet debt-to-income ratio requirements.

Consider the front-end ratio, too

The debt-to-income ratio that takes housing costs and monthly debt costs into account is called the "back-end" ratio.

Lenders also calculate the "front-end" ratio.

The front-end ratio is simply the amount you spend on housing, including mortgage, taxes, and insurance. Your other debts don't matter with this calculation -- only your total housing costs compared to your income.

The ideal front-end ratio lenders look for is 28%. If total housing expenditures exceed this level of gross income, lenders may not give you a mortgage or may charge higher rates.

Getting pre-approved for a loan

While you need to decide on your own what you think you can afford, your opinion won't matter much if no lender will give you a mortgage or you can't borrow enough to buy even the cheapest house in your area.

To find out exactly how much a mortgage lender is willing to loan you, get pre-approved before you start shopping for a home. This involves submitting your financial information to mortgage lenders, having your credit checked, and providing proof of income.

If your lender approves you for a bigger loan than you've decided you can afford, ask the lender to write you a pre-approval letter with the smaller amount you're comfortable borrowing. You'll take this letter to your realtor and present it to sellers.

What if you can't afford a house?

There's nothing more frustrating than wanting to buy a home and either getting denied for a mortgage or deciding you can't really afford it. This can be an especially big problem for people who live in areas where housing is very expensive.

If you can't afford a home, don't get discouraged. Saving for a larger down payment can help you qualify for a better interest rate and make mortgage payments lower so you're better able to afford monthly costs.

You can also consider options such as looking for a cheaper home you could fix up over time, or buying a home that has room for tenants or roommates who can help you subsidize costs.

Don't buy a house you can't afford

The most important thing when deciding how much house you can afford is to truly look at all factors associated with affordability.

You don't want to be house poor or constantly struggling to make your mortgage payments, so go through the process of deciding how much income will be devoted toward housing costs and decide if it's sustainable.

By buying a home responsibly and avoiding purchasing more home than you can afford, your house can be both a good investment and a source of joy, instead of a financial albatross that leaves you stressed out all the time.

You deserve to love your home, and that starts with being a financially responsible buyer.

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