Range - Home Buying Series - Part II: What can I afford?

Home Buying Series - Part II: What can I afford?

If you’ve already decided to buy, you might be asking yourself how much house can I really afford? The first step should be to determine your budget for home shopping.

Anders Skagerberg
Writer

Reviewed by Updated
December 7, 2023

TL;DR

Can’t decide whether to rent or buy your next home? We recommend going back and reading Part I of this blog series . If you’ve already decided to buy, you might be asking yourself how much house can I really afford? The first step should be to determine your budget for home shopping.

DETERMINING YOUR HOUSING BUDGET

So, you're thinking about buying a house. But you have questions…

These questions are 3 of the most commonly asked among potential home buyers, by far. There are several ways of arriving at the answers.

In Part I of our Home Buying series, we discussed some of the reasons why you might want to rent your next home versus purchasing it outright. Today, we’ll dive into affordability and how you can arrive at a realistic budget that won't leave you house poor.

house poor

/adjective/

  1. A house poor individual is anyone whose monthly housing expenses account for a very large percentage of their monthly budget. Individuals in this situation are often short of cash to cover other items and tend to have trouble meeting other financial obligations, such as car payments or education costs for children. Alternatively, this can be a person who uses most (if not all) of their after-tax cash and investments for purposes of meeting their home down payment requirements. House poor individuals can often be forced to limit discretionary expenses, carry balances on credit cards, dip into savings, sell other assets, or downsize in order to meet their financial obligations.

Let’s examine affordability, which typically comes down to two main items:

  1. How much is the house going to cost per month?

  2. How much is the house going to cost upfront?

Of course, anyone could go to Zillow or Redfin today and start looking for the luxury home of their dreams while disregarding the purchase price or monthly payment required.

When you’re looking to establish a maximum home purchase price range, there are three key things to take into consideration:

  1. Down payment and closing costs
  2. Monthly housing payment
  3. Total debt-to-income ratio (DTI)

THE MAIN WAYS TO ARRIVE AT YOUR MAXIMUM PRICE

Let's assume the following facts for this scenario:

Who: Married Couple
Age: 35
Location: Washington, DC
Gross Household Income: $250,000
Credit Scores: 815 | 800
Desired Price Range = $800,000 - $1,000,000
Down Payment % = 15% or more
Liquid After-Tax Funds Available = $200,000

A. Determine the maximum monthly housing payment based on the % of your gross income.

For years, a general rule of thumb has been to keep your monthly housing costs to approximately 30% or less of your gross income:

This concept was developed in the 1930s when the government began measuring housing affordability.

Mortgage lenders can be even stricter — many don't like to see a potential homeowner spend more than 28% of their income on housing.

B. Determine the maximum monthly housing payment based on the debt-to-income (DTI) ratio.

Next, we have the debt-to-income ratio (DTI).

Using our same DC couple, here are some additional facts about their monthly income and debt commitments:

Debt

Income

*PITI = Principal + Interest + Taxes + Insurance

C. Factor in other monthly housing expenses and back into the maximum principal and interest payment.

Earlier in Parts A and B, we looked at the maximum monthly housing payment.

Monthly payment inputs:

  1. Loan Principal
  2. Loan Interest
  3. Property Taxes
  4. Homeowners insurance
  5. HOA
  6. Utilities & Repairs

From the $6,100 maximum payment, we have to subtract additional expense assumptions.

D. Determine feasibility for the amount of downpayment and closing costs required upfront.

A down payment is the amount of money you pay upfront when buying a house.

Downpayment (Typically 5% - 20% of purchase price)

  1. 20% is the most common to avoid PMI.

Potential sources of down payment:

  1. Cash on hand
  2. After-tax investment accounts
  3. Up to $10,000 from a qualified retirement plan (first-time home buyers only)
  4. Gifts from family members

E. Consider the mortgage financing and back into the top end of your budget range!

NEXT STEPS

Based on a comparison of all of these factors, you can weave your way through the numbers to arrive at the ballpark price range you should be considering when shopping for your dream home.

Before embarking on the purchase of a new home, list your requirements, make a plan, and decide on a budget and timeframe. Then research your home loan options and choose the one that is the best match!