How Much Should You Spend On A House?

After deciding to buy a house, the next order of business is determining how much you should  spend. The amount of home you can afford will depend on several factors, including your monthly income, credit score and lifestyle.

Understanding how all of these affect how much you can spend on a house should lead to a simpler, more streamlined home buying experience.

Factors That Influence How Much You Can Spend On A House

Here are the most important factors to consider before reaching a conclusion on how much you can afford to spend on a mortgage:

• Income: You can use your income as a starting point when calculating how much you want to spend on a house.
• Debt: Your debt and monthly expenses factor into how much you can spend on bills each month.
• Cash reserves: You’ll need cash on hand to cover for your down payment and closing costs. It also helps to have a little bit left over so you can show you can make a certain number of mortgage payments in the event of temporary income loss.
• Credit profile: Your credit profile, including your credit score and payment history, will impact how much a lender is willing to let you borrow.

Now that you know the key ingredients that play a role in how much you should spend on a house, here are a few steps that will walk you through the decision-making process.

Step 1: Determine How Much Home You Can Afford

First, determine how much of your monthly income you can spend on housing. Be sure to leave yourself a reasonable cushion for savings, insurance, taxes and other expenses.

A good way to begin is by analyzing your debt-to-income ratio (DTI). Your DTI is a numerical representation of how much you spend on recurring debts each month. When reviewing your mortgage application, a lender will look at your DTI to determine if you can afford to take on more debt. Your DTI can also help you decide whether you should be renting or buying at this time.

How To Calculate Your DTI

Calculating your DTI is relatively simple. You only need to include monthly debt payments in your debt calculation. Your debt obligations might include:

• Rent
• Child support payments or alimony
• Student loan debt
• Auto loan payments
• Personal loan payments
• Minimum payments on any credit cards in your possession

You don’t need to include expenditures such as groceries, utility bills and taxes.

After adding up your monthly debt payments, divide by your gross household income. Then, multiply that number by 100 to convert your DTI to a percentage.

For example, suppose your total monthly debts equal $2,000 and your gross monthly household income is $5,000. To find your DTI, just divide $2,000 by $5,000. In this example, your DTI is 0.40, or 40%.

What DTI Lenders Are Looking For

A high DTI means you’re less likely to pay back your loan. As a general rule, lenders like to see that you have a DTI of 50% or less before they issue you a loan. This indicates you’re more likely to have the cash flow available to repay your loan, and it makes you a more attractive borrower to mortgage lenders.

If your DTI is greater than 50%, you’ll have a tough time finding a loan. You may want to take some time to reduce your debt before applying for a mortgage. As a general rule, you shouldn’t spend more than about 33% of your monthly gross income on housing. Spending more on your mortgage each month risks leaving you house poor, with too much of your monthly income going toward your home.

Using Your DTI As An Indicator

Once you know your DTI, you can get a good idea of how much you can afford to pay monthly for your mortgage. If your ratio is approaching 50%, you’ll want to keep your housing expenses consistent or lower them if possible.

Your monthly rent payments don’t include other costs associated with owning a home, such as insurance and taxes. To stay at the same DTI, you’ll likely end up taking a payment that’s below what you’re currently paying in rent if you’re renting.

If you have less debt, you can be more flexible. For example, suppose your monthly debts equal $2,000 but your income is $8,000 gross. This puts you at a 25% DTI. In this instance, you could afford to take on more debt and a larger mortgage. The lower your DTI, the more likely you are to be approved for a mortgage.

Step 2: Estimate How Much You Should Spend On A Mortgage

To calculate your ideal home price, you must consider two factors that influence how much you’ll pay for your loan: the length of your mortgage repayment term and the interest rate.

Mortgage Repayment Term

Your mortgage repayment term is the total length of your mortgage in years. If you have a term of 30 years on your loan, you’ll make a payment every month for 30 years. After this period, your loan is fully matured and the lender closes your account. The most popular mortgage repayment terms are 15 years and 30 years.

However, lenders can create their own custom loan offerings. At Rocket Mortgage^®, you can get a repayment term as short as 8 years or as long as 30 years.

Taking a longer mortgage repayment term lowers your monthly payments, possibly letting you buy a more expensive home. However, you’ll pay more for your loan over time with interest charges.

Interest Rate

Your interest rate depends on a number of factors, including your credit score, your loan structure and current market conditions. Even a difference of a tenth of a point in interest can mean paying thousands more for your loan over time, so it’s worth the effort to shop around to get the best rate possible.

Step 3: Consider Additional Costs Of Homeownership

There are a few other payments to weigh when you’re deciding how much you can afford to spend on a home.

Homeowners Insurance

Homeowners insurance isn’t a legal requirement to own a home. However, most mortgage lenders won’t lend to borrowers who don’t have homeowners insurance. Homeowners insurance protects you against damage to your home from hazards such as fires, break-ins and lightning storms.

Your homeowners insurance rate will vary depending on your individual circumstances, but you can expect to pay $93 – $246 per month for your premium depending on the size and location of your house.

Property Taxes

Every homeowner must pay property taxes to their local government to fund establishments such as public schools, libraries and emergency services. Your property tax rate will vary depending on where you live. If you’re shopping for a home in a specific county, know the effective tax rate to estimate your tax liability.

Mortgage Insurance

If you buy a home with less than a 20% down payment on a conventional loan, you must pay private mortgage insurance (PMI). PMI is insurance that protects your lender if you default on your loan. PMI raises your monthly mortgage payment. However, you can cancel your PMI once you reach 20% equity in your home.

You’ll be responsible for paying another type of mortgage insurance, known as MIP, for at least the first 11 years after taking out an FHA loan. If you made a down payment of less than 10%, you’ll be on the hook for MIP for the life of the loan.

Closing Costs

Closing costs are one-time expenses you pay when you close on your loan. Closing costs include appraisal, title insurance and attorney fees, among other costs. Expect to pay 2% – 6% of the loan amount in closing costs.

It’s also important to keep in mind that variable expenses such as utilities, maintenance and repairs will also come out of your budget when you own your home.

Step 4: Compare Homeownership Costs Against Your Budget

Now that you know the full cost of homeownership and have a rough idea of how much you can afford to spend a month, consider your household expenses. Before committing to a mortgage, you need to be absolutely sure you can make your premium, insurance and tax payments.

If you don’t already have a household budget, track your expenses for a few months and see where your money is going. Look at the amount of money you have coming in and compare it to the full costs of homeownership. As a general rule, your homeownership expenses shouldn’t consume more than 33% of your monthly budget.

If your anticipated homeownership expenses take up more than 33% of your monthly budget, you’ll need to adjust your mortgage choice. A longer mortgage repayment term and less expensive house can lower your monthly payment.

The Bottom Line

The amount you can afford to spend on a home depends on various factors. Once you have an estimate of what you can afford, compare it to your current household budget and assess how a mortgage payment would impact your savings and DTI.

If your income comfortably covers the mortgage payments, you’re more likely to be approved for the loan. However, if too much of your income goes toward other expenses, you might want to reconsider your housing budget and consult a licensed financial expert who can provide valuable guidance on how to proceed.

Ready to buy a home? Start your mortgage application with Rocket Mortgage today.