Whether you're already saving for a down payment on a house, or you're just starting imagine what it would be like to rent instead of buy, there's one question you have to answer before you can get serious about homeownership: How much can you afford to spend on a house?
Even if math isn't your strong point, it pays to do some work upfront to determine how much money you can afford to spend; then you can shop accordingly. Here's how to determine your ideal home price.
Figure Out Your Monthly Household Take-Home Income
For individuals who are buying a house with a steady income, this part is easy. How much take-home pay (after taxes and other deductions like health insurance) do you see every month?
People who work in industries like food service might need to track income over time to get a sense of what their monthly take-home income is; you can't always predict your tips or work hours, but if you keep track over a period of time, you can usually see how everything evens out. Pay attention to the seasonality of jobs like this, too -- it's not uncommon for some jobs to experience busy times of year interspersed with slow periods, and if you only track income during the busy times, you'll wind up overestimating your take-home pay for the year.
Freelance or contract workers whose business is more sporadic might also need to track income over time in order to get an accurate sense of what they are bringing in. Start with regular clients who contract month-to-month, then add in special projects to figure what an average month income looks like for you. In most cases, it's better to underestimate -- you'd rather have a mortgage payment you can handle easily than one you'll have to stretch to accommodate.
Determine Your Monthly Mortgage Payment
Most experts recommend you spend no more than 25% to 33% of your monthly take-home income on housing. But remember you're not just paying back the mortgage loan on the house; you will also be paying loan interest, homeowners insurance, and property taxes. But for now, get started by figuring out what 25% to 33% of your monthly take-home income actually is, and use that as a jumping-off point.
For example, if between you and your spouse, you take home $6,000 every month (after taxes and health insurance and any other deductions or expenditures), then 25% is $1,500 and 33% is $2,000.
Factor in Any Debts
How much do you owe on your student loans? What about credit card debt or car loans? If you pay child support or alimony, you should factor that in, too. It's best to consider your debts as part of the deductions that happen before you see any money from your paycheck. If you'll continue paying these debts for the foreseeable future, then they aren't part of your take-home income ... it's promised to somebody else.
It's not always possible to repay all of your debt before you buy, but if you can get rid of some items -- especially high-interest debt, like credit cards -- before you start considering homeownership it will really improve your overall outlook. It will raise your credit score, potentially get you a better mortgage loan, and provide you with additional take-home income, not to mention the peace of mind of knowing you're no longer indebted to that creditor.
Consider Other Expenses
These have been mentioned, but it's worth digging into a bit deeper. A monthly mortgage payment not only includes the loan you're paying back and the mortgage loan interest; there are other fees you will be responsible for paying.
A big one is homeowners' insurance, which is required by most lenders (if something happens to your house, such as a wildfire, the lender needs assurance there's a way to recoup the investment they made when they loaned you the money. With insurance there's a better chance you can rebuild and keep living in the property). Homeowners' insurance covers many major disasters, but not all of them. Flood and earthquake insurance are considered extra in many areas, so if those are common or even somewhat likely, you might consider getting extra coverage.
If you already have an insurance agent for your auto or renters' insurance, you might ask their recommendations for insurance in that area. Sometimes you don't have a lot of options with homeowners' insurance; your agent can estimate what you'll be spending, and can let you know if there are other policies available that can increase your coverage.
You'll also have to pay property taxes on the home you buy. It's pretty easy to look up property tax information online if you want to start estimating what you'll pay, and many online calculators factor in property taxes.
Two more potential expenses include mortgage insurance (if your down payment is less than 20%) and homeowners association fees, if any. You don't necessarily need to know what these are upfront, but it's useful to remember they exist when you're trying to use an online calculator to figure out what you can afford.
Do You Have a Down Payment?
If you've bought a car, then you might be familiar with the concept of a down payment; it's money you pay when securing a loan to offset the total amount of the loan you're taking out. Many traditional loans require at least 20% of the home's total value down upfront; for a house that costs $200,000, you should have $40,000 saved as a down payment.
You don't have to have a full 20% of the home's sales price saved, many mortgage lenders will still provide a loan if you have 10% or even less. However, if you don't have 20%, you'll have to pay mortgage insurance on the loan for the duration of the loan, which usually ranges between 0.5% and 1% of the total loan. You can refinance your loan after you've paid it over six months, or if you have over 20% equity built up in your house, but there's no guarantee that mortgage rates are going to remain stable, so it's best to come up with the biggest down payment you can.
If you own a house and plan to sell before buying a new home, then you’ll probably have a full 20% down payment, but there's no guarantee. It depends on when you bought your house, what you paid, what home prices have done since, how much equity you in it, and how much you still owe. A mortgage lender or real estate agent can help you know how much you can expect to net after you sell your house.
Use Online Calculators to Determine Home Price
Now that you know what you can put down on a home and how much your ideal monthly mortgage payment would be, you can use an online calculator to determine your price range. Calculators usually include the most recent mortgage interest rates being offered, which make them a useful tool, but make sure you pay attention to different adjustable fields so you can insure you're getting an accurate calculation. For example, most calculators assume you have a 20% down payment, so if you don't have a full 20% and the calculator isn't adjustable, keep looking until you find one that is.
Remember the other fees, too -- taxes, mortgage insurance, homeowners' insurance, homeowners association fees, and additional property insurance. If you can't find a calculator online that will allow you to factor all of these expenses into your monthly mortgage payment, it might be time to talk to a mortgage broker; they can help you figure out what price range would generate a monthly mortgage payment in your 25% to 33% take-home income range.
Closing Costs Enter the Picture
It would be nice if the mortgage payment and down payment were the only things you needed to consider when buying a house, but there are other costs you should be prepared to cover to close the transaction. The house needs to be appraised and inspected, and the buyer is often pays both. The title company handling the closing will also need to be paid. Fees for the title search and title insurance (if you decide to get it) are also on the table.
One thing some buyers forget is this: Closing costs are negotiable. If you're in a buyer's market and the seller is motivated, you may be able to ask the seller to pay for closing costs, or to negotiate a split of some kind where the buyer handles the appraisal and inspection and the seller pays for any other closing costs associated with the transaction. Maybe you're not ready to talk to a real estate agent yet -- but when you do ask them what (if any) closing costs typically get negotiated in your market and to recommend where you might save money.
Don't Forget Utilities and Maintenance
As a new homeowner, you're going to be responsible for the heating, water, electricity, internet, and other utilities that make the house livable. If the roof starts leaking or the furnace goes out, there's no landlord to call -- you are it! If you can maintain a nest egg to deal with repairs, they are less stressful when you have to deal with one ... and if you don't, there's no harm in being prepared!
Other Questions to Ask Yourself
There are a few other variables that can influence your ability to afford a house and how much house you can afford. Before you start shopping, ask yourself these questions about where you are and where you need to be:
How much are you currently spending on rent, and how easy is it for you to make that rent payment every month? If you're stressing out about making rent, then you probably want a mortgage payment that's less than you're spending now, if possible.
How solid is your credit? Your mortgage interest rate and some terms of your mortgage loan are directly tied to your credit score -- in fact, some lenders won't even consider a mortgage unless your credit is above a certain threshold. Could you pay down current debt to raise your score? What else can you do to improve your credit before buying?
What kind of access do you have to down payment funds? Are there relatives who might help you with a down payment, or are there any programs in your area that offer down payment loans or grants, especially to first-time buyers? (Your mortgage broker can be a good resource for learning about these.)
Talk to a Mortgage Broker
If you haven't already, start a conversation with a mortgage broker about what you can afford. Of course a broker wants to help you secure a loan, but mortgage brokers can also help you figure out what to do to put yourself in a better position to buy in a few months or even a year. Many mortgage brokers have access to credit counseling resources and can inform you about down payment loans or grants, so it's worth contacting them early in the game and using them as the resource they can be.
Don't have a mortgage broker? Find a real estate agent you trust and ask for a recommendation -- agents work with all kinds of mortgage brokers and know which ones can work quickly and effectively, and which ones take a bit more nudging. Even if you don't feel like you're ready to buy, it never hurts to talk to experts and implement their advice.