Section 1.4

Calculating How Much Home You Can Afford

When you're thinking about buying a home, one of the most important things you can do is take a hard look at your finances and figure out how much home you can afford. It's important to be honest and realistic with yourself so you don't find yourself in a financial bind months or years down the road.

To help you figure out what you'd be comfortable spending, we'll cover four things you need to do before even starting to look at homes.

1. Evaluate Your Income

The very first thing you should do is to take a long, hard look at your income. This includes what it is currently and what you expect it to be in the future.

You want to make sure you have a consistent, reliable income that's likely to continue, which means you need to honestly consider your future job and salary prospects.

If you're not sure what your future income might look like, ask yourself some of these questions:

  • Do I think I'll stay in the same field?
  • Are there opportunities to advance?
  • Is my industry stable and in demand?

The answers to these questions can tell you a lot. For example, if you answer no to the first question because you're thinking about changing careers in a few years, there's a good chance your income will decrease.

So, when looking for houses, you'll know to look for one that's a little less expensive than maybe what you'd qualify for now. That way, when future-you changes fields in 5 years, and you take a pay hit, you'll still be able to afford your mortgage payment.

2. Take a Critical Look at Your Spending Habits

Maybe even more important than your actual income is how you spend it.

Being a responsible homeowner means you can budget enough money each month to cover all of your bills, including your housing payments, groceries, credit card payments, and other items.

One great way to evaluate your spending habits is by calculating your residual income. We discussed this topic briefly in Section 1.2 of this guide, and it's a helpful tool you can use to figure out how much of a house you can realistically afford, even if you aren't getting a VA loan.

The reason why calculating your projected residual income is potentially so helpful is that it tells you how much discretionary funds you'll have left each month to pay for necessities like food, clothes, and more.

Calculating Residual Income

Another handy aspect of residual income is that you can use it early in the process to figure out what the maximum monthly loan payment you can afford is. Here's how it works in three easy steps:

  1. Start with the normal residual income calculation by subtracting your monthly expenses from your net monthly income. However, DON'T include your projected monthly loan payment, since this is what we're trying to figure out.
  2. Look up the VA's residual income tables to see what the recommendation is for your geographic area and family size.
  3. Take the number is Step 2 and subtract it from the number in Step 1.

The number you end up with in Step 3 is the maximum monthly mortgage payment you can afford if you want to stay within the recommended residual incomes guidelines. Even if you aren't getting a VA loan, these recommendation amounts are still a wise and prudent ballpark to aim for.

Then, when it's time to start actually talking to lenders about getting pre-approved, you can tell them, "I can only afford a monthly mortgage payment of $X." Once they know this information and they determine the interest rate you qualify for, they can then tell you what home price will keep you within budget, which will only make shopping for a home that much easier.

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3. Understand Your Debt Load

Though your spending habits may influence the amount of debt you have, you can take it one step further by calculating your debt-to-income (DTI) ratio.

TKnowing what your actual debt load is and how much of your income it takes up is a good way to clearly see how much of a mortgage payment you can afford.

Calculating Your DTI

Although we briefly discussed how to calculate your DTI in Section 1.2 of this home buyer's guide, it's such a helpful way to figure out what you can afford that we had to include it here again.

As a reminder, to calculate your DTI, you simply divide all of your major, recurring debts by your gross income. In this calculation, unlike with the residual income one above, it's critical that you include your projected mortgage payment in this calculation so you can actually measure its effect on your debt ratio.

Just as a note before you calculate, most financial gurus believe that 50% DTI is the absolute maximum DTI someone can afford.

Knowing the recommended maximums for DTI can help you determine what size of mortgage debt you can take on because you can calculate your projected debts and compare it.

EXAMPLE

If you calculate your DTI using an estimated mortgage payment of $2000, and that puts your DTI ratio at 51%, then it's obvious that a $2000 mortgage payment is too much for what you can afford.

To find a sweet spot you're comfortable with, try plugging in smaller and smaller projected mortgage payments until you end up with a DTI ratio you're comfortable with. Once you hit that sweet spot, you know you've found the projected mortgage payment you should aim for.

One thing to consider is that the lower your DTI is, the better your chances are of being able to afford your home and everything else that comes up. If your DTI calculation is not quite 50%, but it's still high (in the 40–50% range), you should still really consider how such a high DTI might affect your quality of life.

For example, even if you're not at the maximum, that high of a DTI could still make your finances really tight each month, which would mean you won't have as big of a buffer to weather unexpected financial issues while still being able to meet all of your mortgage and other debt obligations.

Consider ALL of the Costs Associated with a Home

Often a lot of first-time home buyers forget to take into account all of the other costs associated with owning a home.

These include things like closing costs, paying for home maintenance and repairs, furnishing and decorating the home, etc. etc.

With closing costs, for example, they are calculated as a percentage of the home's loan amount. So, not only does a more expensive home mean a bigger monthly mortgage payment, but it also means more expensive closing costs.

To put it into numbers, 2% closing costs on a $250,000 home are a lot less than 2% closing costs on a $700,000 home. (With these examples, it's a difference of $5,000 in closing costs vs. $14,000 in closing costs.)

Bigger homes also take more money to fully decorate and furnish, since they tend to have a lot more space and square footage you need to fill.

And, of course, we can't forget maintenance, though a lot of new home buyers do. At least until their furnace goes out or their roof starts leaking.

If you're thinking of buying a fixer upper as a way to save money, just make sure you really consider if you have enough money to actually afford a home that will need lots of updates and repairs. Where will that money be coming from, if you're not financing it?

Don't Buy a Home That Maxes Out Your Budget

When considering how much of a home you can afford, it's important to remember that it's usually not a good idea to push your budget to its maximum limit.

Instead, it might be better to consider a slightly less expensive home so you'll be able to enjoy it no matter what the future brings your way.