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Buying a new home should be exciting but it should also provide you with a sense of stability and financial security. Living month to month, with barely enough income to meet all of your obligations, the threat of foreclosure looming if you slip up—well that’s the wrong kind of excitement. That’s why it’s so important that you know ahead of time the answer to that very important question, How much house can I afford?
The 36% Rule: The Original Mortgage Affordability Calculator
In order to avoid the nightmare scenario of buying a house that breaks the bank, you’ll need to figure out a housing budget that makes sense for you. One How much house can I afford? rule of thumb that can be helpful in doing so is the 36% rule, which says that your total debt payments should never add up to more than 36% of your gross (i.e. pre-tax) income. In practice, that means that for every pre-tax dollar you earn each month, you should dedicate no more than 36 cents to paying off your mortgage, student loans, credit card debt and so on.
This is more a rule of thumb than a strict limit, but most banks don’t like to make loans to borrowers with bad debt-to-income ratios. Although it’s possible to find lenders willing to do so (often at higher interest rates), the thinking behind the rule is instructive. If you are spending 40% or more of your pre-tax income on pre-existing obligations, a relatively minor shift in your income or expenses could wreak havoc on your budget. Banks don’t like to lend to borrowers who have a low margin of error. That’s why your pre-existing debt will affect how much home you qualify for when it comes to securing a mortgage.
But it isn’t only in your lender’s interest to keep this rule in mind when looking for a house; it’s in yours too. Since lenders tend to charge higher interest rates to borrowers who break the 36% rule, you’ll probably end up spending more on interest if you go for a house that places you beyond that limit. Furthermore, while the difference between the house that eats up 45% of your monthly income and one that only takes 35% is likely not huge, that extra 10% of income can be critical if your financial situation changes (like say your utility payments rise or gas prices skyrocket). With something as important as a house, it’s nice to have a bit of a cushion for when things go wrong.
The Down Payment and the Cash Reserve
Another key number in determining the answer to How much house can I afford? is your down payment. The larger the down payment; the larger the house, right? Well, yes, but before you go and empty out your savings account, keep in mind that lenders generally want you to have a cash reserve remaining after you’ve moved in. Why? Having some money in the bank after you buy is a great way to help ensure that you don’t find yourself worrying about the two dirty words in homeownership: default and foreclosure. The question isn’t just Can I afford a house? It’s Can I afford a house and still have some money left over as a buffer?
While maintaining a debt-to-income ratio under 36% protects you from minor changes in your finances, a cash reserve protects against major ones. At a minimum, it’s a good idea to be able to make three months’ worth of housing payments out of your reserve, but something like six months would be even better. That way, if you experience a loss of income and need to find a new job, or if you decide to sell your house, you have plenty of time to do so without missing any payments (and, in turn, wrecking your credit).
Think of your cash reserve as the braking distance you leave yourself on the highway—if there’s an accident up ahead, you want to have enough time to slow down, get off to the side or otherwise avoid disaster. A good home affordability calculator (like ours!) will make sure you have this cash reserve at the end of the homebuying process.
So now we have two guidelines that can help you figure out the answer to How much house can I afford? The first is the 36% rule, which says that your debt-to-income ratio should stay under 36%; that is, your total debt payments, including your housing payment, should never be more than 36% of your income. The second regards your cash reserve: you should always try to keep at least three months’ worth of payments in the bank in case of an emergency.