How Much House You Can Afford and the Lame 25% Rule

Right now, mortgage rates are attractive.

As a result, the temptation to buy is great, especially for first-time homebuyers who want to get in now while they can save big.

However, just because you think now is an excellent time to buy does not mean you should. Make sure you know how much house you can afford on your income before you jump in.

How Much House Can I Afford?

When determining how much house you can afford, the banks will do a calculation based on how trustworthy you are with a mortgage.

While that number is usually higher than what Dave Ramsey would recommend, factors that influence your eventual mortgage payment include:

Credit Score

The better your credit, the more favorable of terms you can expect from your lenders. This is why it is important to clean up your credit before you start shopping for a mortgage.

The best way to improve your credit is to get your credit reports from the three big credit bureaus: Equifax, Experian, and Transunion. You can get all three reports for free each year at annualcreditreport.com.

If there are any errors on a report, you need to dispute it with that credit bureau. Also, if there are any delinquent debts, you must get those resolved and have your reports updated.

All actions to clean up your credit will result in a higher score and improve your chances of approval and the interest rates you have to pay.

Debt-to-income Ratio

Your debt-to-income ratio is a metric that banks use to determine your ability to take on more debt. The number is calculated by comparing your total monthly debt payments to your pre-tax income.

While Dave Ramsey preaches the 25% number, banks do not like your mortgages, taxes, and insurance to exceed 28% of your income and your total monthly debt payments to exceed 36% of your income.

If you have a higher credit score you can be approved for a larger mortgage, but in general, you can take your monthly income, multiply it by 0.28, and that will be the mortgage payment the bank will approve with insurance and taxes.

Other Costs to Consider

There are several things you can do to reduce the cost of your first home, but you still might not be able to handle the costs of homeownership. Let’s look at some ways to help determine the answer to the question, “how much house can I afford?”

In some cases, your mortgage plus interest may be more than your current rent payment. But that’s not all. As we mentioned above, homeownership comes with other costs, including:

Property Taxes

You will need to make property tax payments. Whether a yearly lump sum is due or whether you pay monthly with your mortgage payment, this is something to prepare for.

Maintenance and Repairs

No longer can you have the landlord bear the cost of maintenance and repairs on your dwelling. You are responsible for the costs associated with keeping up the home and taking care of it. This can cost more than you might expect.

Utilities

Many people forget to consider the extra costs associated with a home. In many cases, your home is larger than your rental. This means that it will cost more to heat it.

Electricity and water costs are likely to go up as well. And, if your landlord previously paid sewer and garbage collection costs, these are additional expenses.

Falling home values

When renting, your landlord bears the cost of a falling home value. If you buy, though, you could find yourself underwater — especially if your down payment was small. Are you prepared to take the risk that your home will decline in value?

Special Loan Situations

While most people opt for the traditional 30-year or 15-year loan, some people can aquire special loans which makes the home more affordable. The two most common are the FHA Loan and the VA Loan.

How Much House Can I Afford with an FHA Loan?

Mortgages through the Federal Housing Authority have much looser terms than private market mortgages.

If you have a credit score of 500-579, you will need a 10% down payment.  Those with credit scores of 580 or higher can get approved with as little as 3.5% down.

Be aware the FHA loans tend to have more hoops to jump through to get the home approved for the mortgage.

The lower down payment doesn’t change the equation on how much you can afford in your monthly payments, but it can get you into a house much sooner if you do not have the upfront cash.

How Much House Can I Afford with a USDA Loan?

A USDA loan does not require a down payment and there is no limit to the size of the mortgage. The loans are geared toward improving housing in more rural areas and for low to moderate income households.

While the terms are excellent, the problem with USDA loans is that they make you jump through several hoops to get a home approved for the loan. Many people find the hassle of working with the USDA on these loans isn’t worth the favorable rates if you can qualify for another type of mortgage.

How Much House Can I Afford with a VA Loan?

VA loans are available to active duty or retired service members and their spouses. The loans have as little as zero dollars down payment and 

The rates on these loans are competitive with traditional mortgages, and those who qualify can enjoy zero PMI even if with a zero dollar down payment.

Being able to qualify with no down payment is great, but make sure the final mortgage payment plus taxes and insurance still fit your budget.

Rules of Thumb

25% of Salary Rule of Thumb

Here’s a question I recently received from a friend and reader about how much house he could afford on his income. He referenced Dave Ramsey’s rule of thumb about not having a mortgage payment for more than 25% of your salary:

I have a Dave Ramsey question, PT. I’ve Googled around and cannot find the answer, and was wondering if you knew. Ramsey states that you should spend no more than 25% of your income on your mortgage.

Do you think he wants you to calculate property taxes and insurance in your “mortgage payment,” or do you think he is simply calculating principal and interest?

In my answer, I said, “yes, Dave definitely wants you to include it.” The second comment on this post suggests that he said so specifically in one of his newspaper columns. Further, taxes and insurance are guaranteed, so you should consider them.

I went on to say that a rule of thumb (most are kind of lame) is limited in its simplicity.

For instance, I can go out and get an adjustable or variable rate mortgage payment that’s less than 25% of my take-home pay today, and tomorrow the housing market could crash another 30%, rates could go through the roof, and I could lose my job. Owning the home outright as quickly as possible sounds like a better rule for the future.

The 28%/36% Rule

The 28%/36% rule means that your mortgage should be no more than 28% of your total income on housing related costs and 36% on all debts (mortgage, credit cards, car, etc.). 

For a quick example:

If you make $5,000 a month and have $600 in debt payments, then you can afford up to a $1,200 mortgage.

For most people this lends a little more flexibility and takes into account other debts. With Dave Ramsey, you won’t be buying a house until all your other debts are paid off.

Once again, this is a “rule of thumb” scenario and you have to consider your personal situation.

How Does Your Debt-to-Income Ratio Impact Affordability?

Every lener will look at your DTI (debt-to-incom-ratio). They use this metric to determine the risk involved in lending you money. 

Lenders will want to see your DTI be less than 43% but some will allow up to 50%. As we said the rule of thumb section, getting that down around 36% is going to make your life much easier.

You can also use DTI to determine how much mortgage you should take out. Using the 28%/36% rule and an income of $5,000, we know that your mortgage should not be more than $1,400 (5,000 x 0.28 = 1,400).

Test to Find Out What You Can Afford

Before you buy, it is a good idea to go for a “test run” with the increased costs of homeownership.

One thing you can do is take 30% of your expected mortgage and interest payment and add it back on. So, if your expected mortgage and interest payment is $1,100, add $330 so that your total estimated monthly costs are $1,430.

Then, consider the difference between what you pay now for your rental and the estimated cost. If you pay $850 in rent now, it means that you will pay an extra $580. Can you afford that much house?

Let’s find out with a real savings test.  Next, open a high yield bank account. Put that extra $580 in the account every single month. Do this for at least four months.

Are you having difficulty making the new “payment”? If so, you might not be ready to purchase a home. The higher costs may exceed your ability to pay for them.

Before you buy a home, you need to make sure that you are truly ready to shoulder the costs. Otherwise, you will be house poor and will strain your monthly cash flow. You could end up in a worse position than if you continued to rent.