If you’re looking to buy a new home, then you’re likely asking yourself, how much house can I afford? How much mortgage can I afford, and what’s a reasonable monthly payment to take on? You don’t want to get in over your head, but you also don’t want to live in a shoebox in the middle of nowhere. Where does the balance lie?
This guide will help you answer the question, "How much house can I afford?" based both on the numbers and your overall happiness. To begin, let's go over some general guidelines to consider when buying a home.
Buying a Home: General Guidelines
There’s a common misconception around buying a house, and it’s that you should buy the biggest and best house you can afford. However, the house you can buy and the house you should buy are not necessarily the same thing. Note that in this article we are talking about buying your own house to consume and live in, not real estate investing, which is its own topic.
Some banks will lead you right up to the precipice of spending when they offer you a mortgage. They’ll give you a loan that you can just afford to pay, but any big life changes, like getting fired or ill, could push you over the edge into bankruptcy.
Not only is taking on the biggest mortgage you can financially risky, but it also may not do much for your overall life satisfaction. When it comes to house size and location, what we think we need and what actually fulfills us don't always match up.
Figuring out the answer to "how much house can I afford" isn’t just about facts and figures. It also requires that you get introspective and strive to make the best financial and emotional decision based on your resources and needs.
Before exploring issues of personal needs in greater depth, let’s take a look at the hard numbers. What percentage of your income should go toward housing payments?
Key Rule of Thumb: Spend No More Than 30% of Your Income
To figure out, how much home can I afford, the conventional wisdom tells us to spend up to 30% of our gross income on housing a year, or a little less than one-third. Gross income is what we make before taxes, not our actual take-home pay. We use gross income because the interest you pay on a mortgage is tax deductible.
Regardless of whether you’re making $20k a year or $2 million a year, you should stick to this rule of thumb. You don’t want to overcommit to home ownership payments in case of an emergency, like losing your job or a costly injury.
So, how can you calculate the house price that would correspond to 30% of your income? It's not just three times your income, because you have to consider total housing costs, which include the mortgage principal, mortgage interest, and general maintenance costs. Consider the example below.
Estimating House Price: An Example
You don't necessarily need a mortgage calculator to answer the question "how much mortgage can I afford?" When figuring out how expensive of a house you can buy, you can estimate that the lump sum house price can go up to roughly five times your total income. Why?
The average person gets a 30-year mortgage and pays off 6% of the house price each year. This percentage may vary depending on your exact agreement (typically somewhere between 4% and 8% of the house price), but it's an average that applies to lots of people. This payment refers to total housing costs, which include both the mortgage and other costs.
If 6% of the total housing costs equals about 30% of your income (using the 30% rule of thumb discussed above), then the total house price equates to about five times your income. We can represent this using the variable "h" for house price and "i" for income. Here’s how the math works out:
- 0.06h = 0.3i
- Divide both sides by 0.06
- h = 5i
Let’s say you make about $40,000 per year. Using this guideline, you can estimate that you can afford a house up to $200,000.
While you can spend up to approximately five times your income on a house, you could also choose to purchase a less expensive home (then you’ll have more disposable income for golf or spontaneous trips to Paris!).
Once you figure out the mortgage, or loan, you need, you’ll apply through a bank. Below are three steps you can take to qualify for your mortgage and reduce your monthly payments.
Qualifying for a Mortgage: Steps You Should Take
Unless you’re paying for the house with a suitcase full of cash and gold bars, you’ll need to apply for a mortgage. Most mortgages have fixed interest rates somewhere between 2.6% and 3.7%, and people commonly choose a repayment plan that spans 30 years.
Once you reach this step, your next questions might be, how much mortgage can I afford and how much can I borrow? Banks look at three main factors when determining your mortgage and repayment plan. The first is how much you pay up front as a down payment. The second is your outstanding debts, and the third is your credit score.
These are the three steps you can take to put yourself in the best financial position for getting a mortgage and buying a house.
Step #1: Save for a Large Down Payment
The more money you can pay on a house up front, the less you’ll have to pay per month. With reduced monthly payments and perhaps a shorter term, you also won’t have to pay as much on interest in the long run.
Aim to pay at least 10% of the total house price as a down payment. Ideally, you can pay 20%. On a $300,000 house, for example, a 20% down payment would be $60,000.
Some banks charge an extra monthly payment toward Private Mortgage Insurance (PMI) if you have less than a 20% down payment. Banks want to avoid risk, and a low down payment is one sign of risk. The bigger your down payment, the better contract you’ll get with the lender.
Step #2: Pay Down Your Debts
Another way that banks assess risk is by looking at your outstanding debts. These debts might include student loans, car loans, or other personal loans. The less debt you have, the better deal you’ll get. If you have a huge monthly payment toward student loans, for instance, then you may not appear to be in a good position to put money toward a mortgage.
You should also strive to show a history of consistent, on-time payments. If you’ve let your loans go into default, then you may not get approved for a mortgage. If you’re planning on buying a house, then it’s important that you handle your debts responsibly and work toward reducing them.
Step #3: Build Up Your Credit Score
Finally, your credit score is an important factor when you apply for any kind of loan. Lenders look at your financial behavior in the past as an indication of your financial behavior in the future. The strongest credit scores fall into the upper 700s or 800s.
Now that you have a sense of the numbers - paying up to 30% of your income on housing - what else should you think about as you venture down the path toward home ownership?
Buying a House: Beyond the Numbers
A lot of guides for first time homeowners will urge you to go out and find a house that costs about five times your annual income (or the combined incomes of you and your spouse). While this mortgage calculator estimate may work well for you, assuming no unexpected interruptions in your income, it’s not necessarily the end all and be all in real estate advice.
This mindset urges people to step right up to the limits of their financial profile to get the biggest house in the best location that they can. It prompts you to answer, how much house can I afford, with the biggest possible number. Banks and realtors, of course, are motivated to keep people in this maximizing mindset. But is this way of thinking necessarily the best way to approach buying a house?
How much mortgage can I get and how much mortgage should I get are two different questions. If you think you’ll be happiest with the biggest or most centrally located house you can get, you may be overestimating the importance of house size and location. Let’s consider both of these factors, amount of space and location, individually.
How Big a House Do You Want?
People often want to maximize the amount of space they can afford, but they may not be happier with more space in the long run. Humans have a knack for adjusting, which can have many benefits, but also means that we won’t stay satisfied with material improvements in our surroundings for long.
According to UC Riverside psychology professor, Sonja Lyubomirsky, “Someone who feels elated after upgrading to a big house is likely to soon start yearning for more — an extra bedroom, a pool, whatever it may be. But ultimately, whether we drive a battered truck or a Lexus to work; whether we have hypertension or asthma, our ability to be happy and get happier doesn’t vary much.”
As long as we have a certain amount of comfort and our needs our being met, we won’t get much happier from a bigger house in the long run. People tend to acclimate to the space that they have, and many report higher levels of happiness after minimizing their lifestyles. All too often, extra space just becomes storage for extra stuff.
You don't need to donate all your possessions and join the tiny house movement, but you should take time to think back on your various living spaces. Were you substantially happier in larger spaces? What was the smallest space you’ve lived in and felt satisfied?
Before falling prey to the McMansion mindset, think about how much space would actually make you happy and how much would be unnecessary excess.
Where Should Your House Be Located?
While the size of your house may not be as important as you think, its location can have a large effect on your happiness levels for one main reason: your commute to work.
Several studies have shown that commute time has a big impact on personal well-being. A study conducted at the University of Waterloo concluded that long commutes link with low overall satisfaction in life, while a 2011 study from Sweden connected long commutes with low energy, high stress, and more frequent absences from work due to illness.
While you may not be able to afford a location with the best commute, you should avoid buying a house far away from your place of work. Finding the right house becomes a balance, then, among your finances, the size of the house, and the area where it’s located.
How Much House Can I Afford? Final Thoughts
There are lots of steps that go into buying a house, and you have to take a close look at your finances and personal needs. Generally speaking, you should spend no more than 30% of your income on housing payments (mortgage plus the other costs of home ownership). You can use this rule of thumb to look at houses that cost five times your annual income or less.
While banks might be all too eager to grant you a large mortgage - assuming you can put down a large down payment, are paying down your debts, and have a strong credit score - you shouldn’t necessarily take on the biggest mortgage you can. Taking on any kind of debt is a risk, and you should be cautious about over-committing to a 30-year mortgage if you’re concerned about things in your life, like job security.
You should also consider how much of your monthly income you need for spending in other categories, like a retirement savings account or a January vacation to the Caribbean. Think about what will make you happiest, whether it’s a larger space, a short commute, a location close to restaurants and cafes, or a small monthly payment that frees up your income for leisure activities.
When purchasing a home, you need to think long-term about both your finances and your overall happiness. Once you’ve figured out what you’re looking for, you can make steps to put yourself in the best position for getting a mortgage and buying your perfect house.
