It can be difficult to determine how much you can afford to borrow when purchasing a home. With several factors in mind (your credit, income, spending, and your down payment), there are a few rules of thumb to follow.
And while these rules are more financially conservative, they can help prevent things like foreclosure or being house poor, which basically means not be able to do the other things you really enjoy doing because so much of your income is going towards your house payment. Follow these steps to determine how much you can spend on a home.
The 25 Percent Rule
The most basic guideline is that your house payment should not be more than 25% of your monthly income. However, data from the Bureau of Labor Statistics show that most homeowners with children under the age of 6 in the United States actually spend 36.3% of their income on housing costs, which includes mortgages.
Keep in mind that the 25% rule isn't a hard-and-fast rule. You should consider your individual financial situation. For example, do you have a high amount of student debt or other debt? In that case, you may want to shoot for a lower percentage of your income when buying a home.
It is important to realize that the banks may be willing to lend you more money than you can really afford. It is up to you to determine the right amount for your budget.
Set Your Budget Before You Start Shopping
Before you start shopping for a new home, work out a budget with a potential house payment included. This is to ensure that you can actually afford to pay your mortgage each month.
In addition to your mortgage, you'll also need to factor in home insurance, taxes, and home repairs or upgrades, and maintenance. A recent report found that in 2018, consumers spend an average of $1,105 on home maintenance and $7,560 on home improvements. This is another reason why you don't want to overextend yourself with your mortgage payment.
Work with a Professional
When determining how much you can afford to spend on a home, it's wise to work with a professional. Consider the advice of your financial advisor on whether or not you are ready to buy a home and how much you can realistically afford. You should also consider your debt-to-income ratio when considering how much to borrow for a new home.
Remember, your debt-to-income ratio is the amount of all your monthly debt payments (like your mortgage, credit card payment, car payments, student loan payments), divided by your gross monthly income.
Studies have shown that homeowners with a higher debt-to-income ratio are more likely to have trouble making their mortgage payments.
You should also talk to the loan officer at your local bank or credit union or mortgage servicer. They can help you determine the mortgage that you can afford, plus what you'll need during the application process.
In addition to the down payment, you will need to have money set aside for the closing costs. While it depends on the price of the house, realtors' fees, and other factors, typically, you should expect to pay between 2-5% of your home's purchase price on closing costs.
You should also exercise caution when considering the type of mortgage you choose. Generally speaking, you should choose a fixed-rate mortgage, not an adjustable-rate mortgage. Here's why: while a fixed-rate mortgage's interest rate stays the same throughout the life of the mortgage, with an adjustable-rate mortgage, that amount can go up or down.