The housing market in 2021 has gotten off to a hot start, with record home sales, low rates, and bigger price tags dominating the market. Lenders are pulling out all the stops for homebuyers, focusing on first-timers and low-down-payment programs. Working from home and staying indoors due to the global pandemic is incentivizing homeownership.
If you’re buying a home, especially for the first time, knowing how much house you can afford is essential. Before you hire a real estate agent, search for homes, or receive preapproval from a lender, it’s important to ask yourself, “How much house can I afford?”
There are calculators everywhere on the internet, but if you don’t know the logic behind them, then what are they worth? Read on to learn how to balance your budget when it matters most.
Comfort Level Vs. What You Can Afford
There’s an important distinction to make between your comfort level and what you can afford.
Comfort Level
Your comfort level is how much house you can afford without stretching your financial stability. Life happens quickly; you should have a financial buffer for emergencies and never compromise your debt-to-income ratio.
What You Can Afford
This is the maximum amount of house you can pay for after all monthly commitments are met. Most financial professionals would advise spending below this amount. Lenders will typically offer you more money than you’re comfortable with; that’s why establishing a budget is essential before you seek preapproval.
Know the Three Rules
1. The Mortgage Payment Rule of 28/36
The first rule, often used by lenders, is the rule of 28/36. This rule’s ultimate goal is to determine the maximum amount of money you can spend on your monthly mortgage payments.
- The 28% is referred to as the front-end ratio. This ratio includes principal, interest, taxes, and insurance (PITI).
- The 36% is often referred to as the back-end ratio, comprised of the front-end ratio plus your debt. Debt can include student loans, car loans, child support, alimony, and other relevant sources.
How to Calculate Your 28/36
1. Take your household’s gross monthly income (GMI) and multiply it by 28% (.28 in decimal form). This is the most you should spend on a monthly mortgage payment.
2. Start over; take your household’s GMI and multiply it by 36%.
3. Take the output from #2 and subtract #1. This difference is your monthly debt allowance.
Worked example:
Jane’s family earns $10,000 in gross monthly income (GMI).
First, multiply Jane’s GMI by 28%:
10,000 x .28 =2800
Then, multiply Jane’s GMI by 36%:
10,000 x .36 =3,600
Finally, subtract to find the difference:
3,600 – 2,800 = 800
Jane can spend a total of $2,800 on her monthly mortgage payment. If she follows the 28/36 rule, she can use the $800 difference to pay down monthly debt.
Many sources will simply tell you to accept this rule and move forward, but if your monthly debt allowance is less than what you spend monthly paying debt, you need to consider a lower monthly mortgage payment. The same logic applies to the 28% of the rule. If you don’t feel comfortable allocating almost a third of your gross income to a house payment, scale it back to a more comfortable amount.
2. The Dave Ramsey Rule
Dave Ramsey is a personal finance advisor, internet personality, and real estate investor. His rule is a bit tougher to apply than most, which can benefit buyers who err on the conservative side.
He recommends that you shouldn’t buy a house unless you’ve saved 10% of the total cost for a down payment. He encourages homebuyers to save up as much as possible for this initial down payment because it will save them over time. He urges people to pay off debt, start an emergency fund, and use a 15-year fixed mortgage when they purchase a home.
His rule states homebuyers can spend a maximum of 25% of their after-tax monthly income on a house payment. If your household makes $5,000 a month after taxes, then by Ramsey’s standards, you can afford a $1,250 mortgage payment.
3. The 30/30/3 Rule
This recommendation from personal finance expert and investment banker Sam Dogen combines three separate parts, outlining how much house you can afford.
1. Allocate no more than 30% of your gross monthly income towards a monthly mortgage. If you make $5,000, you should spend no more than $1,500 a month on your mortgage payment.
2. Reserve 30% of your home’s value in cash or low-risk assets before you buy. Saving in advance can offset potential financial risks. Dogen recommends using 20% of these funds as a down payment and 10% as a cash cushion.
3. Multiply your household’s gross annual income by three to find your maximum target home price. The 3x indicator helps you find homes that are affordable.
These three guidelines can reassure homebuyers on what they can afford. Once you know your monthly budget, it’s time to look at the total cost of a home and get preapproved.
Tying It All Together
Using one of the three rules above, you can determine what you’re comfortable spending on a monthly mortgage payment. Now you can go to a lender with confidence and borrow the amount you need, not the amount offered.
If you use the 28/36 rule, expect an aggressive guideline on the maximum amount to borrow. The Dave Ramsey rule, in contrast, is a conservative approach to buying a home. And finally, the 30/30/3 rule is a well-rounded substitute if the other rules aren’t for you. Regardless of how you calculate comfortable monthly payments, take control of your finances and consult with a professional financial advisor if you have additional questions.
This post was not written or reviewed by a professional financial advisor, and the suggestions should not solely be used to make financial decisions.
