How much house can I afford?

Home affordability calculations should take in a lot of factors including Debt-to-Income (DTI) ratios, down payment savings, expenses & budget, lifestyle and goals.

Here is a quick list of all the factors to consider when deciding home affordability:\

• Debt to Income Ratios (or Rule of 28 or 36)
• Down Payment
• Monthly Budget
• Lifestyle Aspirations
• Financial & Life Goals

(1) Debt-to-Income Ratio (Rule of 28 or 36)

The 28/36 rule is a commonly recommended rule-of-thumb to figure out how much house you can afford. According to this rule, you should not spend more than 28% of your gross income on all home related expenses or spend more than 36% of gross income on all loans and debt, including home loans, car loans or other types of debt such as student loans, credit card or personal debt.

Front-end Debt-to-Income(DTI) ratio

This calculated all home related expenses as a percentage of gross income. Home related expenses includes mortgage, property tax and HOA fees.  Typically it is recommended that all housing related expenses be 28% or less of monthly gross income.

For example, if your monthly gross income is $10,000 (or $120,000 annually), you combined home expenses should not be more than $2800 per month (inclusive of mortgage, property tax, HOA, etc).

Backend Debt-to-Income(DTI) ratio

The backend Debt-to-Income ratio is preferred by lenders because it accounts for all debt, not just housing related debt. This ratio considers loan payments such as student loans, credit card loans, personal loans, car and auto loans and any other type of debt payments in addition to housing loans. Lenders typically like to see this ratio be 36% of the monthly gross income.

For example, if your monthly gross income is $10,000 (or $120,000 annually), your combined debt should not be more than $3600 per month (inclusive of all types of loan such as home loans, car loan, student loan, credit card monthly payments and personal loans).

(2) Down payment

The down payment you are able to afford will significantly influence how much house you can buy.

Here is why:

• Putting down a 20% down payment ensures that you do not have to take out a Private Mortgage Insurance (PMI) to reduce the risk to the lender.
• You will take out a smaller mortgage and pay less in interest and monthly payments. You may even pay less in mortgage rates because lenders consider you less risky. Moreover, you will build more equity in your home right from the beginning.

(3) Your Budget & Expenses

It is important for you analyze all your potential expenses (including housing, groceries, food, utilities, entertainment and everything else) and set a realistic budget. Make sure that your other non-housing expenses are manageable if you want to buy an expensive home. Do you have any other fixed costs that may be hard to handle? It is also important to remember that there is often a lifestyle inflation when people buy a bigger home and you need to factor this in your budget. Your utilities, cleaning and maintenance expenses might increase significantly.

(4) Lifestyle

People often overlook this, but lifestyle is perhaps one of the biggest factors driving home affordability. What kind of lifestyle do you wish to have, and what tradeoffs are you willing to make?

For example, if you love to travel frequently with the family or donate to charity, you may not wish to max out the home value – even if lenders approve it.

Alternatively, if you want a large home with a yard, maybe you have to make tradeoffs in other aspects of your lifestyle. It is important to discuss this openly with your family members and figure out the kind of lifestyle you want as a family – and plan your home buying based on this. 

(5) Financial and life goals

This is also a good time to think deeply about your family’s financial and life goals besides home buying.

For example, it may be wise to consider the following questions:

• Does one parent want to stay home and care for kids?
• Do you want to retire early and travel?
• Do you plan to pay 100% of your kids’ college expenses?

These are just some of the questions to think about when buying a home.