The simple rule of thumb is to spend less than three times your gross income on a home.
I’m here to show you the guts behind that little guestimate/guideline and give you some insight as to how your lender may determine whether it agrees with how much house you think you can afford. I’m going old school with pencil, paper and a wonky little calculator app. Follow along with your own calculations, if you wish, to answer the question, how much house can you afford?
Lenders consider lots of factors when they evaluate a loan application, among them, their borrowers’ Total Debt-to-Income Ratio (DTI). This magic number compares the total amount of debt you’re obligated to pay each month with your gross monthly income (income before taxes and other deductions).
Lenders may allow up to 43% for a Total DTI Ratio. But there’s no need to be an overachiever and hit that maximum. Do yourself a favor and try to keep your Total DTI Ratio low. Consider a conservative cap of 38%.
The lower you keep this number, the more financial freedom you’ll have with regard to saving and your living expenses. And don’t forget you may need to furnish your new home or buy a lawn mower or a new toilet.
Total Monthly Debt includes your Proposed Monthly Housing Expense and the rest of your debt.
We’ll circle back to Proposed Monthly Housing Expense; as for All Other Monthly Debt, include the following monthly payments in your tally:
Your lender may have additional requirements with regard to what it considers as monthly debt.
Don’t include your current rent payment or monthly living expenses like groceries, utilities, cell, cable, entertainment or gym membership. You’ll need to consider your living expenses in your total monthly budget but your lender will not use them to calculate your Debt-to-Income Ratio.
Here’s an example:
Let’s say your gross annual income is $50,000; your gross monthly income, $4,166. Based on that figure, your All-Other-Monthly-Debt-to-Income Ratio would look like this:
My, what a lovely, manageable ratio.
So if your Total All-Other-Monthly-Debt-to-Income Ratio is 15% and you set a cap of 38% for your Total DTI Ratio, you should be able to comfortably afford spending 23% of your gross monthly income toward your monthly housing expense.
Here’s how that works out, based on our example:
That $958 has to cover:
The thumb tells us that with a gross income of $50,000, you could afford a house valued at $150,000 or less. Depending on local home values and real estate tax rates, miscellaneous expenses and your down payment amount, $958 a month may be plenty or it could be nowhere near enough. Let’s see where that amount will get you based on national medians and averages:
Private mortgage insurance is most often paid monthly and by the borrower — that would be you — and is included in the total monthly mortgage payment (Total PITI).
Something to note is that private mortgage insurance is cancellable. In our examples, depending on the down payment amount and an annual home price appreciation rate of 3%, it could be cancelled between months 33 and 61, reducing your mortgage payment by the monthly MI amount — a nice little bump in disposable income!
(Yes, the end of this post is finally here — thanks for sticking with me.) Our examples show that if you have a gross income of $50,000 and a Proposed Monthly Housing Expense of $958, financing a $150,000 home with the right down payment and financing combination is very do-able.
If you’ve read all this, you still feel confused (welcome to the club), and you just want a quick rough answer – try our home affordability calculator. Rather than thinking about the price of a home in relation to your salary or savings, just enter a number you think you could live with for a monthly mortgage payment. We’ll make a lot of complicated assumptions and give you the price of a home you might be able to afford with a 10% down payment.
