The First-Time Buyer’s Guide to Knowing What You Can Afford

If it’s your first time buying a house, you probably have a lot of questions. The most important one at the start of your home buying journey is “How much house can I afford?” Fortunately, there are simple guidelines you can use to give you a range. With that in hand, you’ll be ready to begin your house hunt!

What Determines Home Affordability?

A home is affordable if you can pay your mortgage and your other house-related expenses and still have enough left over to service your other debts (ex, credit card payments, student loans).

The 28/36 Rule

The 28/36 rule is a good basic measure of home affordability that lenders frequently use. This rule states that:

• Your total monthly housing costs shouldn’t exceed 28% of your gross monthly income.
• Your total monthly debt payments (including housing) shouldn’t exceed 36% of your gross monthly income.

When you’re working out “how much house can I afford,” use your gross monthly income (your income before taxes) as a starting point. For example, if you earn $5,000 per month before taxes, your housing costs should stay under 28% of $5000, or $1,400, and your total debt payments should stay below 36% of $5000, or $1,800.

How Do Lenders Decide Home Affordability?

Lenders use complex formulas and risk estimates to determine house affordability for each borrower. When asking “How much house can I afford?” Use the same figures that lenders use:

• Your income
  Lenders are more likely to approve your loan if your housing expenses (including your mortgage, property taxes, and insurance) are no more than 28% of your gross monthly income.
• Your existing debt
  Lenders look for a debt-to-income ratio of under 36%, including your mortgage and all other monthly obligations such as credit card payments and car loans.
• Your credit score
  With a higher credit score, you can usually get a better interest rate on your mortgage. That increases the amount of home you can afford. Here’s an idea of how your credit score affects home affordability:
  • 740+ credit score: Best rates available
  • 680 to 739: Good rates
  • 620 to 679: Higher rates
  • Under 620: Financing will be more difficult to get, but specialized programs are available.
• Your down payment
  The more you can put down, the less you will need to borrow, and the smaller your monthly payments will be. With lower mortgage payments, you can afford to pay more for a home.
• Interest rates
  Even with a good credit score, your home affordability will be affected by changes in mortgage rates. An increase of as little as 1% can raise your monthly payment by hundreds of dollars. A mortgage calculator will show you how interest rate changes affect home affordability.

How to Calculate Your Monthly Mortgage Payment

Calculating your monthly mortgage payments will help you figure out your home affordability and how small changes can affect it. Think of it as a budgeting tool and a way to get insights into where you can make changes.

Principal and Interest

This is the main part of your mortgage payment. The principal is the outstanding amount of the loan itself, while the interest is the cost of borrowing the money. Mortgage payments are always the same, but the proportion of the payment that goes towards principal vs interest changes over time.

If you want to do the math yourself, use this formula to calculate your monthly payments:

M = P [ r(1 + r)^n ] / [ (1 + r)^n – 1]

Where

• M = Monthly payment
• P = Principal loan amount
• r = Monthly interest rate (annual rate ÷ 12)
• n = Number of total payments (loan term × 12)

You can also use an online mortgage calculator for this task. The advantage of a mortgage calculator is that you can adjust the numbers to see how they can change home affordability.

Property Taxes

Property taxes are typically 1% to 2% of your home’s value annually. This can vary widely by area, so check with your real estate agent what the local rates are and if any increases are expected.

Property taxes can be paid to your lender along with your monthly mortgage payment. Your lender will hold the money in an escrow account for remittance to your county or municipality when they are due. You can also choose to pay your property taxes directly to your local tax authority.

Homeowners Insurance

Homeowners insurance is required by lenders. It protects the home itself and your personal possessions. Many lenders allow you to pay your home insurance as part of your monthly mortgage payment.

Private Mortgage Insurance

This type of insurance protects the lender in case you default on your mortgage payments. It is required if your down payment is less than 20% of the home’s purchase price, although some types of loan products, such as USDA loans and VA loans, don’t require private mortgage insurance.

Private mortgage insurance is between 0.3% to 1.5% of the loan amount annually, and it ends when your equity in the home reaches 20%.

Using a Mortgage Calculator

When using an online mortgage calculator, enter realistic numbers for:

• Your desired down payment amount.
• Current interest rates.
• Property tax rates in your target area.
• Estimated insurance costs (homeowners and PMI).

Use the mortgage calculator to evaluate different scenarios such as monthly payments based on different loan amounts, interest rates, and loan terms. This will help you answer the question “How much house can I afford?” and show you what home affordability looks like under different conditions.

Improving Your Home Affordability

If you want to afford more house, try these strategies:

Improving Your Credit Score

A better credit score means lower interest rates and lower monthly payments, which improves your home affordability. To achieve this, work on paying down your existing debts, make all your payments on time, don’t open new credit accounts, and report any errors on your credit report.

Save for a Larger Down Payment

A bigger down payment means lower monthly payments and no private mortgage insurance if your down payment is 20% or more of the purchase price of the home. A larger down payment also makes you more competitive in a sellers market, meaning you have more negotiating power.

As a First-Time Home Buyer, How Much House Can I Afford?

The financial aspects of buying your first home can be overwhelming, but many other homeowners have done it, and you can do it too. Start by answering the question “How much house can I afford?” and partner with an experienced REMAX agent to guide you through the rest of the process.