But HOW MUCH CAN YOU AFFORD?
This is by far the question that I get asked most often and because you’re here I’m guessing you’re curious too.
Well, the long and short answer of it is… it depends on the single biggest factor in any home buying or financial equation. YOU.
What are the expenses for a new home?
So when we talk about affording a home we need to look at first how much it costs on a monthly basis to own a home. There are some expenses that you might not even think about when buying your home. here’s a list of the main expenses for your new home:
- Principal and interest payment– the repayment of the loan to the bank
- Mortgage insurance– if you put less than 20% down on a property you will be required to get mortgage insurance which protects the bank against you defaulting on the loan (since it’s riskier for them once someone has put less than 20% down)
- Home Owner’s Insurance– insurance on the property and its contents in case of unexpected loss or circumstances
- Real Estate Taxes– taxes you pay to the county and state for the land and property you own
- Home Owner’s Association Fees (HOA Fee) if you live in a community that has shared amenities like a condominium complex you will have a fee you pay monthly or yearly for upkeep and maintenance
- Utilities– Items like Electricity, Water, Sewer, trash, cable, internet
- Any other expenses that you will incur- things like maintenance, lawn care, etc
What can you afford?
So when I say “what you can afford?” this is based on the amount of money you personally can afford to put towards your monthly mortgage payment each month.
There are a few ways to do this, but I like to look at what you make each month and then take a look at your average monthly expenses.
So let’s take a look:
Start with income. Specifically, the amount of money that gets deposited into your bank account each month for your household (this is your net income or income after taxes). If you have an income that fluctuates look at what your average monthly take home pay is over the year.
Next up are your expenses. Review all of your monthly expenses (not including any housing expenses like rent, utilities, etc unless you are keeping your current property) you have each month. These can be debts, food, childcare, student loans, everything that you pay for on a monthly (quarterly/yearly) basis you will want to include.
I think it’s important to get an average of a few months of expenses to make sure you’re including everything and getting a more realistic view of typical expenses throughout the year. If you want a spreadsheet that will calculate your average expenses for you and show you how much you are spending each month on each expenses category, you can download my spreadsheet here:
After you’ve reviewed your average expenses, go through each expense line by line and ask:
- Is everything accurate?
- Is there anything else you should be including?
- Are you putting enough away for savings/401k/emergency funds?
- Are there any future payments (like childcare or car payments down the road) you need to consider to add to the monthly expenses?
- Is there anything like memberships that you might be able to eliminate quickly to get your expenses down?
Take your average expenses, put them into separate categories (if you haven’t done so already). Make any changes you need, by increasing or decreasing certain categories based on your above answers and put these into a sample budget for you to follow (you can do this in excel they have spreadsheet templates or just do a simple Google search). The total of all of these line items will be your projected monthly expenses before housing.
Now take a look at your monthly income less your projected monthly expenses before housing. The remainder will be used towards your new future housing payment. Remember you will need to stay safely under this amount for the total payment, that includes the mortgage payment, insurance, taxes, utilities, etc.
Here’s an example, let’s say Mary’s monthly net income (what gets deposited in her bank account) is $4,000 her average expenses including all of her debts, expenses and what she puts away for her savings are $2500.
That means the amount she can use towards her monthly housing payment is roughly $1500.
We can estimate this amount she has to set aside about 30% towards items outlined in the above section for expenses for a new house like real estate taxes, homeowners insurance, utilities and other expenses (remember this is just a quick estimate whenever possible it’s best to use the most accurate numbers for your specific situation and if you are putting less than 20% down and you will have mortgage insurance or you have an HOA it may be more than this).
Let’s look at the numbers, we’ll go back to Mary’s example again:
When we take out the estimated 30% of the other monthly expenses that are not the mortgage payment we get $1,050.
So a quick and easy estimation trick I use if interest rates are close to 5% and you are looking at a 30-year loan for each $100,000 is $500. In Mary’s case, this shows she can spend roughly $1,000 on her new mortgage payment ($500 goes into $1,000 twice and 2 multiplied by $100k is $200,000) so she can roughly afford $200k with these numbers.
This gives you a good quick and easy guide of how much you can afford, obviously this is just an estimate but something you can do pretty quickly in your head.
In fact, are you doing this right now? If not why not follow along? I have a simple spreadsheet that you can download that has each of these calculations done for you and you just have to include your personal information. When completed, it will show you based on your numbers what you can potentially afford and prequalify for.
How much house can you afford?
This easy spreadsheet does all of the calculating for you!
If you want an actual loan calculator you can check this out. Fill it out like this and hit “calc”:This shows Mary can afford a mortgage for a loan of up to $195,595.70 with a $1,050 mortgage and interest rates at 5% (you can Google the most accurate rates too).
Downpayment. Next, we’ll talk about how much you’ve decided you can afford to put as a downpayment on the property. If we look at the amount of roughly $195,500 that Mary can afford we can add her down payment on top of the loan amount. The bank will require at least a 3.5% down payment or higher for the purchase of Mary’s primary home (the home she will be living in).
Remember the down payment and the closing costs are different, a good rule of thumb is to budget between 2-3% of the purchase price on closing costs but these can vary depending on local fees.
The best person to discuss closing costs with is a local mortgage person from a bank, credit union or other mortgage company who can give you a Good Faith Estimate that outlines all of the fees associated with closing on your new property (make sure you shop this around as it gets closer).
For this example Mary will put $11,000 down on top of the closing costs (which is roughly 5%), therefore the estimate of what she can personally afford is $206,500.
Here’s the math so you can follow along:
How different is the new proposed payment from your current housing payment?
Another good way to make sure you can afford a new mortgage payment is to look at how this compares to your current monthly housing payment.
Let’s say Mary’s rent is $1,100 a month, her utilities/insurance and any other expenses for housing are an additional $150, so she has a total current payment of $1,250 each month. That’s a difference of $250 from her current payment to the new proposed payment as shown below:
Based on these numbers she will have to come up with $250 more a month than her current housing payment. So she needs to really evaluate this and ask herself a few very important questions:
- How easily am I making my current monthly housing payment? Is it a struggle each month or am I financially comfortable with this?
- What can I spend less on each month that can help me contribute $250 towards my housing payment each month?
- Am I being realistic about my future spending and budget that still allows me to save as well as pay all of my expenses? Or do I need to readjust this?
- Do I feel comfortable with all of these numbers?
Mary can decide if this payment is right for her based on her answers to the questions above. If this new mortgage payment is more than she feels comfortable with then she can lower her monthly payment (which will also adjust her loan amount and the total cost for what she can afford) or if this seems feasible and she feels pretty comfortable making these payments.
What you can afford is substantially more important to your financial future than what the bank shows you can get a loan for, but it doesn’t take into account items the bank will look at like your credit score and your debt to income ratio.
What does a loan pre-qualification mean? And why do you need it?
When a bank, mortgage broker, lender anyone who is looking to give you a mortgage to buy a house look at your basic financial information and determines based on their financial calculations if you can “afford” a house.
Typically they will ask for but not need proof of right away:
- Your income and the income of anyone else who will be included in the mortgage
- How long you have been at your current job (they typically like to see 2 years in the same job or at least same line of work and at least two years of tax returns if you’re self-employed).
- What your monthly long-term debts are each month (ex: credit cards, car payment, student loans)
- If you know your credit score (at this point lenders may not pull your credit yet) and how good you think your overall credit is
- How much you have currently in all of your bank accounts to use as a down payment, closing costs and for reserves (money in your bank account in case something unforeseen occurs).
Because they don’t pull your credit at this time and they haven’t asked for any documentation you can see this will only be an estimate of what you can qualify for a mortgage.
If you want a more concrete loan qualification where they examine your credit, all of your financial documents and have you fill out a loan application this is called a loan pre-approval.
Whenever possible make sure you get a loan pre-approval so that the lender or bank has as much information on you as possible to avoid any red flags before you put in a contract on a home.
What can you pre-qualify for?
When we took a look at what you can personally afford this is much more difficult because you have so many different factors to take into account, no one person is in the exact same financial position as you and only you know what your priorities are in your financial future.
When the bank looks at what you can qualify for it’s much easier because they are just looking at their specific calculations which removes anything personal from their equations.
If you’d like I have a quick and easy pre-qualification spreadsheet that will do all the work for you and go a little more in depth. Sign up below.
How much house can you start shopping for?
Here's a spreadsheet that does all of the calculating for you!
Let’s take a look at how this will look for you. We again look at Mary’s income and expenses, but this time there are a few things different.
Income. For the pre-qualification the bank will look at Mary’s gross pay, this is the amount that she is paid before any taxes are deducted, as opposed to before we looked at what was actually deposited in Mary’s bank account each month.
Expenses. For Mary’s expenses we’ll only take a look at what she has in long-term debts, so any items that she is required by a bank or court to pay on an ongoing basis. These include things like credit cards (but only the minimum payment), student loans, car payments, etc. As you can see this doesn’t take into account any other expenses that Mary may have each month.
Mary has the same income but this time we will be looking at her gross income before taxes (instead of net income which is after taxes) and she has $25 as a minimum monthly credit card payment and a $200 car payment for her debts.
So we subtract her long-term debts from her gross income and we get an amount she has remaining for all her expenses including her new mortgage.
The bank or lenders prefer to have your mortgage payment to be under 36% debt to income ratio. So that means with your new mortgage plus all of your debts should be less than 36% of your gross income (there are some loan programs that will go higher than this, but this should be only be considered in rare circumstances and please be sure you know you can afford the monthly payment each month).
This total mortgage payment will need to include the additional items such as taxes, insurance, home owner association fees, etc. The bank, however, will not be taking into consideration monthly maintenance and utilities included in your monthly payment.
If we look up a loan for $1,719 less 20% for additional monthly expenses (remember this is an estimate because it doesn’t include maintenance and utilities) just the mortgage payment would be $1,375.20 if we add her $11,000 down payment she would be able to pre-qualify for $267,174 house.
So what’s the difference between what you can afford and what you can pre-qualify for?
If we look at the difference in payments (remember what Mary personally can afford includes maintenance for the house, utilities anything housing related) and what the bank will look at is only mortgage insurance, real estate taxes, insurance, and HOA fees.
As you can see in this case Mary can qualify up to $1,701, but that looking at her finances she really would only fee comfortable spending only up to $1,500 each month and that includes everything related to housing.
Some people when they look at these numbers can go back and look at their monthly expenses in their budget and find a way to pay for that additional $219 a month, plus all of the additional utilities and expenses each month.
Others may decide this is more than they can afford. That’s why it’s important to compare the two and only you can decide what’s best for you.
So like with your credit cards, the bank will offer you up to a certain amount but do you really want to use it all?
So do you know what can you afford?
If you still have questions I do have a class that walks you through step by step on the pre-qualification process.
If you want to know how much you can afford, figure it out now, if not make a date and stick to it. Go through your current income and your expenses and then see how much you can afford to put towards your mortgage payment each month then look out how much you can get pre-qualified for.
Good luck and I’ll be here if you need help!