If you’re considering buying a house, one of the first steps is figuring out if you can afford one. Mortgage lenders take various factors into consideration to determine how much money they will loan to you. If you can afford a house, the next question is: How big of a house can you afford? Having a realistic house budget before you shop for houses in person will save you time and heartache.
Estimate your maximum mortgage
You can calculate a rough estimate of how big of a house you can afford by using the same methods that mortgage lenders use: debt-to-income ratios. Mortgage lenders calculate debt-to-income ratios to ensure they give lenders mortgages proportional to their existing means. While debt-to-income ratios differ slightly among mortgage lenders, they still tend to be similar across the board. There are two debt-to-income ratios. They are known as the “front ratio” and the “back ratio,” also known as the housing ratio and debt ratio. Written as 33/38, these percentages are a good rule of thumb to measure your maximum mortgage.
Divide total monthly housing costs by your monthly income to get your housing ratio. Monthly housing costs include mortgage payments, property taxes, and insurance. For example, if you make $4,000 per month, then your total housing cost shouldn’t be above $1,320 per month, or 33% of your total income.
Using an easy mortgage calculator, you take the maximum housing cost and maximum monthly debt payments to find out how big of a house you can afford. Start out by taking your maximum housing cost and subtract out average property taxes and average homeowner’s insurance by state so that you are left with a maximum mortgage payment. Then adjust the house price on the mortgage calculator until the monthly payment matches your maximum monthly mortgage payments. That leaves you with the maximum house price you should be shopping for.
Continuing our example with $1,320 maximum housing costs and assuming you are buying a house in Oregon, you would subtract about $48 per month for average Oregon homeowner’s insurance and take into account the 1.09% property tax in Oregon. That makes $1,320 into $1,272 subtracting homeowner’s insurance, and $1,072 subtracting about $200 for property tax. Making monthly mortgage payments of $1,072 with a 4% 30-year mortgage, you will want to be shopping for houses $224,500 and under, assuming you have enough for a down payment, typically 5%-20% of the house price.
Divide your total monthly debt payments, including your total housing costs, by your monthly income to get your debt ratio. Debts include credit card debt, car payments, student loan debt, and alimony payments. Auto and life insurance are not included in the debt ratio calculation. For example, if you make $4,000 per month, then total debts you pay monthly shouldn’t be above $1,520 per month, or 38% of your total income.
You can only afford a house that’s 33% of your income if your other debts are less than 5% of your income. If you’re making $4,000 per month, that means having less than $200 in debt per month. If you have more debt than that, no worries—you’ll just have to adjust your maximum mortgage rate to be lower. Find out what percentage of your monthly income currently goes toward debts, then subtract that number from 38 to get the percentage of your income that can go toward total housing costs.
For example, if you pay $400 in student loans monthly, then that’s 10% of your total monthly income. 38% minus 10% leaves you with 28%, or $1,120 of your monthly income that can go toward total housing costs. Repeat the steps under housing ratio with this lower number to find out the maximum house price you should be shopping for.
The amount a mortgage lender is willing to lend you also depends on factors such as the down payment you will make and your credit score. If you have enough money to make a large down payment and near-perfect credit, it’s likely mortgage lenders will be more flexible with how much money to loan you.
Whether you can afford a large house or not, make sure you’re sure that you’d rather buy than rent before taking steps toward a mortgage, and know that while our culture assumes that bigger is better, small houses have their perks, too.
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