It seems like everyone has a rental horror story. Maybe it’s about a landlord whose idea of repair consists solely of duct tape. Maybe it’s the stress of rising rent. Or maybe you’ve just woken up one too many times to find yourself sharing your bed with an uninvited colony of insects.
Whether or not the decision is made alongside a parade of ants, when the pot finally does boil over, many of you will end up uttering (or yelling) the same four words: It’s time to buy.
As exciting as that pivotal moment is, it also brings a host of new considerations. But before you can decide where to buy or what you’re looking for, you have to figure out how much house you can afford.
Calculate How Much House You Can Afford
While it can be tempting to immediately start browsing the listings, the first step in knowing your budget is to take these into consideration:
- Your monthly take-home pay.
- The size and terms of the loan you’ll take out.
- The size of your down payment.
- The hidden costs of homeownership.
How Much Money Do You Actually Take Home?
The first order of business when making a budget is to determine how much of your salary is actually available to you.
In general, employers quote you the amount they pay out (your gross pay) rather than the amount you take home (your net pay). There are several deductions taken out of your paychecks for things like taxes, insurance and retirement contributions, depending on your workplace.
When you think about what you can afford for a new home, you should always think about your net pay, because that’s the amount of money you will have at the end of every month.
For help finding your net income, check out our guide on how to calculate take-home pay
For the sake of this article, let’s assume Sam and Pat have a gross household income of $100,000 per year. They’ve calculated that this means a net income of $68,000, or around $5,660 every month.
First Things First: The True Cost of Your Home
Buying a home is a unique experience, unlike anything else you’ve ever purchased before. That’s because the price you see at the top of the listing isn’t really what you’ll end up paying.
Here’s where things get tough for the first-time buyer. Even though the house you want has a certain value on paper, due to added costs, as well as the long-term interest on the loan you will take out to buy it, you will inevitably end up paying much more for the house over the length of the term.
In fact, based on the length of that mortgage, you could pay almost double the price you bought the home for. While that’s frustrating to think about, it also has a major impact on some of the decisions you have to make up front, and it all begins with your financing.
Your Mortgage or Line of Credit
Unless you’ve been saving for years — or perhaps you’ve recently robbed a bank — chances are you won’t pay for your home in cash. The majority of home buyers will be taking out a loan to pay for the bulk of their purchase.
Of course, as we all know, there’s no such thing as free money. A new home is a major investment, and that means any loan you take out for it is a major commitment as well. When it comes to a loan of this size, there are three things that should take center stage in your decision process:
Here’s What’s Really in Your Monthly Payment
Your monthly payment is the total amount you will owe every month for the length of the loan, based on the term, the interest rate and the principal:
- Term: The term of a home loan is how long it will take you to pay back both the principal and the interest. One reason buying a new home is such a commitment is that the average term of a U.S. mortgage is 30 years! Depending on your financial situation, though, there are options available to make this shorter. A 15-year term — if you can afford the higher monthly payment — will drastically cut down on the true price of your home.
- Interest rate: Every loan comes with interest. This is the amount above and beyond the principal that you have to pay back to the lender. It’s important to note that this interest is compound interest, which means that interest is calculated every month based on the total amount owed.
- Principal: This is the total amount that the lender will provide to you. For a home loan, it’s equal to the total value of the home minus your down payment.
Unless your down payment is more than 20% of the value of the home, this payment will also include private mortgage insurance, which is a fee charged by a lender to insure them against default.
It’s this monthly payment number more than any other factor that typically determines how much house you can afford.
It is recommended by experts to spend no more than 25% of your take-home pay on your housing. When we apply this to Sam and Pat we find that they would be able to afford a monthly payment of $1,415.
Keep in mind that while the 25% recommendation is a strong one, it won’t necessarily be a recommendation shared by your lender. In fact, your lender may very well try to get you to take on a bigger loan than you should. Stick to the 25% rule, however, and you’ll be keeping your home costs affordable as well as realistic.
The Importance of Your Down Payment
Though it’s rare to buy a house in cash, the amount of money you have available on hand greatly influences the selection of homes you will be able to afford.
In fact, the size of the down payment you can make on your home can change not only the price range of homes you’re looking for, but also the true cost of the loan.
And the more money you have to put down, the less the total principal of your loan will be. With that in mind, most experts recommend paying no less than 10% of the price of your home upfront.
Even still, 10% is not ideal. Those who are looking to minimize their payments should actually be paying 20%. If you can afford to put down 20% of the value of your home, you will not have to pay private mortgage insurance, which can substantially lower your monthly payments.
Now, Sam and Pat have been thinking about buying a new home for a while. (A few years ago, they had a bad experience with a leak from the apartment upstairs, and they are so done with that kind of thing.)
In that time, they’ve eaten mostly ramen noodles and rice, they’ve cut the cable cord and most important of all, they’ve kept up with The Penny Hoarder.
Through all that hard work, they’ve managed to save $60,000. That should make a substantial dent in a loan!
The Difference Between Adjustable and Fixed Rates
Even with the most important considerations out of the way, there are still several different mortgage options available, with different interest rates and repayment lengths. Here’s what to look for in fixed and adjustable rate loans:
With a fixed-rate loan, your interest rate is locked in. If it starts at 4.5%, it will always be 4.5%. For homebuyers, this means that if you can get a fixed-rate mortgage when rates are low, you will pay less overall. This is the best option in most cases.
Adjustable rate: If you opt for an adjustable-rate mortgage, then after a set period of time with a fixed rate, your interest rate can change if the market does. There are very few situations in which this is a better option than a fixed-rate loan.
The Hidden Costs of Homeownership
Of course, there’s still more to think about. When you buy a house, you’re not just buying a structure. You’re making an investment. As with all investments, there is a substantial amount of upkeep that you need to pay for just to keep your home in good working order.
There are repairs and renovations, sure, but those are often unexpected and can be covered by an emergency fund. Unfortunately, there are also major expected costs associated with buying and owning property that need to be factored into your base home budget.
Yes, it’s always the taxes that get you! Every jurisdiction has its own property tax rate, and this is often added to your monthly loan payment.
When you’re browsing for a new home, you will generally find an annual tax rate included on the listing. That number is just an estimate and will be updated by your municipality every so often depending on the housing market.
Regardless, it’s a good approximation, and if you divide it by 12, you can get a sense of how much it will add to your monthly payment.
You should never be without homeowner’s insurance. Legally, you’re not required to have a policy on most mortgages, so it may seem like an unnecessary expense.
But if you shop around to find a good policy, this shouldn’t add more than $100 to your monthly payment. If disaster strikes, it may be the only thing that helps you rebuild, which is why a good rule to live by is: If you can’t afford home insurance, you shouldn’t be buying a home.
Some of the most overlooked costs of owning a home are the fees and expenses that come along with the actual purchase of the property.
Since they’re not included in the sale price, they can catch a lot of first-time buyers off guard. In some cases, they may even limit the home you can afford.
That’s because, like the down payment, they often need to be paid in cash, and will cost between 2% and 5% of the price of the home.
What they’re actually comprised of is a lengthy list that includes lawyers’ fees, taxes, inspection costs and other necessities that are unavoidable when buying real estate (for a full list, check here). Keep in mind, though, that the buyer doesn’t typically pay any of the realtor’s fees, so at least you have some respite there.
How would this affect Sam and Pat? Well, they should be taking this amount out of their savings, which will lower the down payment they can make. If they want to keep to a 20% down payment so they can avoid private mortgage insurance, it will affect their total budget for their home.
Sam and Pat: How Much House Can They Afford?
With all that in mind, how do Sam and Pat fare as a couple making $100,000 a year?
- We know that they have an annual gross pay of $100,000, but only take home about $5,660 per month.
- Using 25% of their monthly income on housing, that gives them $1,415 to work with.
- They’ve saved up $60,000 in cash by scrimping and saving, but not all of that can go to the down payment due to closing costs.
- They want to make their down payment as high as possible to lower their monthly mortgage payments. They’re aiming for 20%, so they can take advantage of not having to pay private mortgage insurance.
All told, Sam and Pat are in a pretty good situation. If they looked for a home listed around $260,000, their 20% down payment would be $52,000, leaving them $8,000 for closing costs — right in expected the range of 2% to 5%.
Better yet, with a fixed-rate 30-year mortgage at 4.5% interest, they’d only need to pay about $1,385 monthly, which includes a $1,000 yearly insurance plan and an average 1.15% property tax cost of $2,990 per year.
Making It Easy with a Mortgage Calculator
Thankfully, you don’t have to go through all the math yourself!
There are plenty of reliable online calculators, like this one, which can estimate all of this for you using the information discussed above and ensure that you can stay excited for the new chapter in your life.
Yes, it can be scary. But it doesn’t have to be if you plan ahead.
Curtis Westman is a writer who has gone through the process of buying a new home twice… and who, while writing this, has tried his hardest not to start browsing the listings all over again.