How to Calculate How Much Home You Can Afford

With the spring housing market just on the horizon, it may be a good idea to bump “budgeting for a house” to the top of your financial goals. One mistake we see often is starting the process by getting pre-approved for a home loan. This can present difficulties to prospective buyers, as it’s not uncommon to get pre-approved for more than you’re comfortably able to pay–remember, pre-qualification is an estimate of how much you’ll be able to borrow, not how much you can afford on top of your other monthly expenses. Treating your pre-approval amount as your budget could get you into a sticky financial situation. So, if you can’t rely entirely on the bank to help you calculate your house budget, how do you know how much to save and what price range to look for? Let’s look at a smarter way to calculate how much home you can afford.

Step 1: Work Backwards From Your Cash Flow

Although a home is one of the most significant purchases you can make, planning for one isn’t much different than preparing for any other big purchase: start by examining your current income and expenses. If you already have a budget, you should easily be able to see an overview of your monthly cash flow. If you don’t have a budget yet, learn how to pay attention to spending habits and audit your expenses with these tips. 

Once you have an accurate idea of your monthly expenses and income, use the information to calculate how much you can afford to spend on housing. If you’re already a homeowner and your current mortgage payment fits within your budget, start there. If you don’t own a home yet, it’s time to crunch some numbers. As a general rule of thumb, your mortgage payment should be no more than 28% of your gross monthly income. Free calculators like this one can help you determine how much mortgage and principal you can afford. Keep in mind that your mortgage payment includes property taxes and homeowners insurance, which vary depending on the specific house you buy, so it’s wise to leave room in your budget instead of maxing it out as you search.

Step 2: Determine Your Down Payment

You’ll often hear that 20% is the ideal down payment amount, but that can be difficult to come by in today’s housing market. So, what makes 20% the magic number, and what happens if you pay less (or more)?

Putting down at least 20% of the home’s purchase price helps you avoid PMI (Private Mortgage Insurance). The smaller the down payment, the larger the risk to the bank, which is why PMI is added to conventional loans with less than 20% down. PMI premiums are added to your monthly payments and vary depending on your credit score and how much you borrow. Those extra premiums are difficult to get out from underneath, and require refinancing or paying off 80% of the principal of your home based on the original appraised value, usually with additional stipulations. This can quickly erode your ability to save efficiently for other goals, which is why we recommend borrowing no more than 80% of your home’s value. 

On the other hand, let’s say you can easily afford to put down more than 20%. Should you? It’s tempting to play around with affordability calculators and watch your mortgage payment dip down, but draining your savings on a down payment is a risk that’s not likely to be worth the reward. A home costs more than the down payment and subsequent mortgage payments. You’ll owe closing costs and any expenses associated with moving, not to mention potential repairs. What happens if your furnace goes out two months after you close on your new house and you’ve spent all your savings on a down payment? That reduced mortgage rate won’t keep you warm! Don’t leave yourself house-poor: determine how much you can put down without leaving yourself in a tight spot if an emergency expense pops up.

Step 3: Cover Your Bases

Speaking of emergencies, how do you know how much to set aside just in case? Insufficient emergency savings can leave you in a financial bind, but setting aside too much can mean sacrificing progress toward your financial goals. 

Before you sign on a home, make sure Bucket #1, your emergency fund, is established and the right size, and don’t forget about Bucket #2, your personal escrow fund for the expenses you know will crop up throughout the year. Filling these buckets before you commit to a mortgage payment can help you stay on your feet and on track while still meeting your other financial obligations (like a mortgage!) if you get laid off, have a medical emergency, need to replace the radiator, etc.

Step #4: Be Smart About House Hunting

Lastly, how much house you can afford depends on your big-picture finances, like your debt-to-income ratio and other obligations. If you’re juggling competing goals, like paying off loans and saving for retirement, a financial advisor can help you create a balanced strategy.

Once you know how much you can spend on a house, present your budget to your realtor and stick with it! If interest rates are causing you to worry about purchasing a home, learn why that shouldn’t necessarily stop your house hunt by clicking here. Whether moving for a job, downsizing in retirement, or purchasing your first home, we wish you all the best as you embark on this exciting journey. And if you’d like to help your kids or grandkids as they make plans to purchase a home, watch our video for how to make your help more effective.