By Catherine Alford
February 14, 2020
Money; Getty Images

It’s no secret that buying a house remains a big part of the American dream. For many of us, it can signal we’ve arrived, into adulthood or into the middle-class. But aside from how thrilling the prospect of homeownership may be, the actual process of financially preparing to buy can be seriously daunting.

So, you might be wondering, “How much house can I afford?” Perhaps you have a general idea of how much you’d like to spend, but excitement and emotions of house hunting can make you forget about the math. That’s why it’s so important to have a strong understanding of the home buying process before you set out on the journey and follow these concrete steps along the way:

Step 1: Understand the Home Buying Process

  • Know who you’ll be working with to buy your home.
  • Understand who profits when you buy a home.
Step 2: Write Down Your Priorities and Stick to Them

  • Know what you want in a home and what competing spending priorities you have
  • Talk about and write down what you want, so don’t easily forget once you start shopping and feel the temptation of newer, bigger more expensive options
Step 3: Learn the Difference Between Gross Pay and Take Home Pay

  • Understand that banks calculate how much to lend based on your gross pay.
  • Learn why you should use your take-home pay instead
Step 4: Decide on a Percentage of Your Take Home Pay

  • Once you understand the importance of take-home pay, decide what percentage you want to allocate to your mortgage payments.
  • Take the time to write down other financial obligations you’ll have outside of your mortgage payment.
Step 5: Understand the Impact of Your Debt

  • Learn how mortgage lenders calculate your debt-to-income ratio.
Step 6: Plan for Maintenance Costs and Other Expenses

  • Learn how to calculate potential maintenance costs of your home.
  • Understand the definition of PMI and how it relates to your overall homeowner costs.
Step 7: Build Your Emergency Savings

  • Learn why you need to have emergency savings before you buy a home.
  • Create an emergency fund in addition to your down payment fund.
  • Know who you’ll be working with to buy your home.
  • Understand who profits when you buy a home.
  • Know what you want in a home and what competing spending priorities you have
  • Talk about and write down what you want, so don’t easily forget once you start shopping and feel the temptation of newer, bigger more expensive options
  • Understand that banks calculate how much to lend based on your gross pay.
  • Learn why you should use your take-home pay instead
  • Once you understand the importance of take-home pay, decide what percentage you want to allocate to your mortgage payments.
  • Take the time to write down other financial obligations you’ll have outside of your mortgage payment.
  • Learn how mortgage lenders calculate your debt-to-income ratio.
  • Learn how to calculate potential maintenance costs of your home.
  • Understand the definition of PMI and how it relates to your overall homeowner costs.
  • Learn why you need to have emergency savings before you buy a home.
  • Create an emergency fund in addition to your down payment fund.

Step 1: Understanding the Home Buying Process and Where Incentives Are

The best way to keep your emotions in check and stick to a budget when buying a home is to understand who will be involved in your home buying experience.

You’ll likely work with:

  • Real Estate Agents (Buyers and Sellers)
  • Bankers and Mortgage Brokers
  • Insurance Agents
  • Contractors

All of these people benefit when you spend more. Your real estate agent (and the seller’s agent) earn a commission from the sale of the home you’re buying. Meanwhile, your bank will have an incentive to loan you as much money as you can safely borrow, since a bigger loan means more in interest payments. If you hire contractors, they get paid when you decide to upgrade your home. Your property insurance company gets paid more depending on how much you have to protect.

Title companies and inspectors usually have set fees, but your real estate agent will likely refer them. You might even have friends or family members who push you or encourage you to buy more home or purchase in a certain area.

While there are many great, honest people in these jobs, you have to remember: The person who cares the most about your financial health is you. While others may be well-meaning and encourage you to get the type of house you really want, only you truly know how a home purchase will impact your finances and personal goals.

Here’s a perfect example. When my husband and I bought our first house a few years ago, our real estate agent tried to talk us into increasing our budget. She said if we spent $20,000 more, we could get some of the things we really wanted, like a second bathroom and a two-car garage (a big plus during the freezing Michigan winters.)

She knew we had young kids and would really enjoy having two bathrooms, and she was right. However, at the time, I was earning about half of what I do today. As someone who is self-employed, my income was — and still is — variable. I wanted to buy a house that I knew we could comfortably afford, even if I had a few low-income months in a row. We found one, a small bungalow with only 1,100 square feet. It only had one bathroom and a one-car garage, but we bought it anyway. Do I wish it was bigger? Yes. But, we still live in it today with our two kids and our mischievous dog.

As much as I’d still love a second bathroom (we’re totally going to add one soon) I’m glad I didn’t budge when it came to the budget. I wouldn’t even look at houses in the next price point. I knew they’d be nicer. I knew they’d have better appliances and countertops. And, I didn’t want to be swayed.

Having a house I can easily afford has enabled us to prioritize other things in life like paying down student loans and taking family vacations. So, before you even start house hunting or calculating how much house you can afford, write down your life priorities.

Step 2: Write Down Your Priorities And Stick To Them

If you could do anything you wanted in the world, without having to worry about how much it costs, what would you do? Would you read books all day curled up in a nook? What about traveling the world?

Before you buy a house, you have to consider your priorities — and really be honest with yourself about how you want to spend your time. Having a big house with a massive outdoor kitchen is not going to magically make you into an entertainer if you’re not one already. But, if you’re a person who always has friends over on the weekends, even if you currently live in a small apartment, then maybe a big home for entertaining is for you.

Your house is not going to change who you are. You like what you like, and no matter where you live, you’re always going to spend your time in a way that suits you. Write it down and know this before you start house hunting because it will help you to stay disciplined and on track when you start to see what’s available in your preferred market.

Step 3: Understand the Difference Between Your Gross Pay and Your Take Home Pay

Now that you know your priorities and what professionals you will have to deal with, it’s time to set your budget.

When you go to the bank to talk to a mortgage lender, they’re going to base their decision on how much to lend on you on your gross income. This is the amount of money you earn before you make your retirement contributions, pay your health insurance, and anything else.

Your bank cares about three main things:

  • Your gross monthly pay
  • The minimum monthly payments you make on the debt you currently have
  • The amount of money you’ve saved for a downpayment

There’s an inherent problem with this methodology, though. The reason is the bank doesn’t know your other obligations or your goals.

Your bank doesn’t factor in:

  • How much you spend on daycare costs
  • The fact that you might send $500 a month to an aging parent
  • That the minimum payment on your credit card debt will rise as your balance grows
  • Your desire to send your kids to private school
  • Your increasing property taxes or utility costs after you move

That’s why you have to calculate your own ability to buy a home based on your personal budget, not the bank’s rules. You should run the math using your take home pay not your gross pay. Your take home pay is how much you earn after you deduct:

  • Retirement contributions
  • Health, dental, and vision benefits
  • Social security and medicare taxes
  • State and federal income tax withholding
  • Child support payments

Knowing your take home pay, plus writing out your other financial responsibilities, gives you a much better picture of how much house you can actually afford.

Step 4: Decide on a Percentage of Your Take Home Pay

Now that you know your take home pay and why it’s important to use that in a calculation (not your gross pay), decide on a percentage of that take home pay to use on your house payments.

If you’re more conservative financially, experts like Dave Ramsey recommend spending no more than 25% of your take home pay on your mortgage, home insurance, and property taxes. Other financial experts suggest to keep those home expenses at or below 30% of your take home pay.

So, let’s say you want to hit somewhere in the middle of that margin, let’s use 28% of your take home pay as an example. If your household takes home $6,000 per month after taxes, insurance, etc., multiply that number by 28. You’ll get 168,000. Now, take that number and divide by 100 to get what your max monthly housing payment should be. In this example, that’s $1,680 per month.

Some experts say this estimate should include expenses such as property taxes and home insurance to calculate an accurate amount of what your true housing costs will be. Remember, this is just a ballpark figure, something to give you a baseline as you begin your house search. Everyone’s personal financial situation and comfort level with debt will affect how much house they actually want to buy.

The wildcard, of course, is whether or not you have outside obligations and outstanding consumer debt. If you have credit card payments and student loan payments, that’s going to make your budget tighter.

Step 5: Understand the Impact of Your Debt

Your debt is an important part of the home-ownership equation too. In fact, it’s unlikely you’ll qualify for a mortgage if your debt-to-income ratio (DTI) exceeds 43% of your monthly income. Your debt-to-income ratio reflects how much of your gross monthly income goes towards paying your debts. So, in order to get this percentage, your lender will take your total monthly debt payments and divide that by your monthly income, before taxes and other deductions like 401(k) contributions are removed. Then, you multiply by 100 to get your DTI ratio, which will be quoted as a percentage.

So, let’s say you want to buy a house, and your gross income is $6,000 per month. The mortgage payment on the house you want to buy is $1,500 a month. But, you also make $500 of monthly payments towards your student loans, credit cards, personal loans, etc.

Your house payment of $1,500 per month plus your $500 a month in debt payments means $2,000 per month would be going towards your debt if you bought the house you want. So, divide $2,000 by $6,000 and you’ll get a 0.33. Multiply this number by 100 to get your percentage. In this case, it’s right around 33%. Now you have your debt-to-income ratio.

According to Investopedia, lender’s allow you to have up to a 43% DTI, but they prefer a DTI under 36%. So, in this case, you should be able to afford the mortgage of the house you want because it still leaves room in your budget for everything else you want to do in your life like investing in retirement, traveling, buying clothes, etc.

Why does this matter to lenders? Well, they need to figure out if you will be able to pay your mortgage bills on time every time. If your debt to income ratio is deemed too high, you may not be able to get the loan you want. That means you may have to spend your time saving up for a bigger down payment, which will reduce the amount you have to borrow, lowering your monthly costs.

Step 6: Plan For Maintenance Costs And Other Expenses

Now that you have a better idea of how your debt and your income factor into how much house you can afford, zoom out a little and consider some additional expenses you need to save for as a future homeowner.

For example, how much of a down payment do you have saved for your home? If it’s less than 20%, you’ll likely have to pay what’s called private mortgage insurance (PMI). This is an extra payment on top of your mortgage payment, meant to compensate lenders in case of default. This is money you won’t get back and it’s money that won’t go towards reducing your mortgage principal. The good news is, you can get rid of it as your equity stake gets larger.

Then, you’ll need to have cash on hand for inspections, closing costs, moving, and home maintenance. For example, when my husband and I bought our house, it had two different colors of wood floors. We wanted them to match, and we knew the best time to restain them would be before we moved in. That meant we paid $1,600 for a company to fix our floors right after we paid all our closing costs. It was a tight month financially, but I’m glad we did it. This is the type of cost you might not be ready for or expecting, which is why it’s a good idea to have a savings buffer.

Step 7: How Much Emergency Savings Should You Have When You Own a Home?

According to a recent survey, homeowners spend on average $2,000 per year on home maintenance. And, a Realtor.com article recommends you have 1% to 3% of your home’s value saved and accessible to use for home repair emergencies. So, if your house is worth $200,000, you should have between $2,000 to $6,000 of cash on hand in a separate account earmarked for home emergencies.

Putting it All Together

In sum, in order to find out how much house you can afford, you’ll have to consider a few things:

  • Your take home pay. If you’re married, this is the amount both you and your spouse take home every month
  • The amount of money you send towards your debt every month, because that will determine your debt-to-income (DTI) ratio
  • Verify whether or not you have enough money saved for a 20% down payment. If you don’t, you’ll likely have to pay for private mortgage insurance (PMI) on top of your mortgage payments
  • The cost of your property taxes, homeowners insurance, and other household maintenance

Before you buy a home, it’s smart to:

  • Have a solid emergency fund to pay for any unexpected household expenses
  • Enough money to pay for your down payment, closing costs, and inspection fees without struggling
  • Factor in the cost of moving, any repairs you want to complete before you move in, and any increase in energy costs that might occur as a result of moving to a larger space

Calculations to make using the resources in this post:

  • Your take home pay
  • 28% of your take home pay (or whatever percentage you feel comfortable using)
  • Your DTI Ratio
  • The cost of your other financial obligations (daycare, etc.)
  • The cost you should save for home repairs for the house you’re buying
  • The exact amount of the down payment you can make while still keeping a solid emergency fund

If you make these calculations, you should have a very strong understanding of how much house you can actually afford, not the amount of house your bank says you can afford. When you know this number and truly understand it, it’s easier to say no to your realtor when they want to show you houses above your budget.

Don’t be swayed by outside pressure or shiny kitchens in houses above the price point you set. Buying a home is a serious financial obligation. When you buy one you can actually afford without struggling, it can be something that brings you joy — not financial stress — for many years to come.

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