How much house you can afford

In short

A friend of mine once fell in love with a house on a Tuesday and signed papers by Friday. You can do better than that. Start by adding up what you earn each month before tax, and check what you already owe on cars, cards, and loans. Ask a lender to explain their debt to income limits, and ask for a written pre approval so you know your range. Then work out what you would truly like to pay each month, which may be lower than the lender allows. Add in tax, insurance, upkeep, and cash for the down payment.

The whole of it

What it is

I once watched a neighbor spend an entire spring debating a lawn mower, then buy a house without half that care. It happens. A house feels like a home long before it feels like a number. But how much house you can afford is a plain question with a plain answer, and it has two halves.

The first half is what a lender will let you borrow. The second half is what you are willing to pay each month and still live the life you want. Those two figures are seldom the same, and the gap between them is where most trouble begins. A lender looks at your paperwork. Only you know your family, your worries, and how much you enjoy a night out.

You have probably heard that a home should cost about three times your yearly pay. That is a rule of thumb, and rules of thumb are cheap company. Interest rates change. Taxes change. Your own situation is not anyone else's. So we will work from the real pieces instead.

How it works

If you are holding a pay stub and wondering where to begin, begin with two ratios that lenders use. The first is called the front end ratio. It compares your total monthly housing cost to your monthly income before tax. Housing cost here means the loan payment, property tax, and homeowners insurance, and sometimes association dues and mortgage insurance.

The second is the back end ratio. It takes all your monthly debt payments, including the new housing cost, and divides that by the same income. Car loans, student loans, and minimum card payments all count. Rent does not, since it goes away when you buy.

Lenders set their own limits, and loan programs set theirs. A conventional loan, an FHA loan, a VA loan, and a USDA loan each have their own rules. So ask each lender what ratios they use for your loan. Do not guess.

Then there is the cash side. You need a down payment, and you need money for closing costs, which are the fees paid when the sale is final. If your down payment is under a certain share of the price, many loans add mortgage insurance, which protects the lender and costs you extra each month. You also want a cushion left over after you buy. A furnace does not wait for a good month to fail.

The numbers, and where to find yours

Some of these figures come from law or from the program you pick, so they change and you should look them up. Here is where to look.

For the size of loan that a conventional lender can buy or back, the Federal Housing Finance Agency publishes the conforming loan limit each year. Right now that limit is the current figure, which the official source publishes each year. Loans above it are called jumbo loans and often carry stricter terms.

For FHA loans, the Department of Housing and Urban Development sets the minimum down payment and the loan limits for your county. The minimum down payment for an FHA loan with a strong credit score is the current figure, which the official source publishes each year. You can check your county limit on the HUD website.

For the interest rate, the rate you are offered depends on your credit, your down payment, and the market that week. Ask lenders for a Loan Estimate, a standard three page form that the Consumer Financial Protection Bureau requires them to give you within three business days of applying. It shows your rate, monthly payment, and closing costs in one place, so you can compare offers side by side.

For property tax, call the county assessor or look at the listing's tax record. For insurance, get a real quote. Do not borrow a neighbor's number.

A worked example

Let me tell you about Maria. She is a nurse who earns 72,000 dollars a year before tax. Her monthly income is 72,000 divided by 12, which is 6,000 dollars.

Maria pays 350 dollars a month on a car loan and 150 dollars a month on a student loan. That is 500 dollars a month in other debts.

Suppose her lender allows a front end ratio of 28 percent and a back end ratio of 36 percent. Those are figures for this example only. Her lender may use others.

Front end first. 28 percent of 6,000 is 0.28 times 6,000, which is 1,680 dollars. So her housing cost should stay at or under 1,680 dollars a month.

Now back end. 36 percent of 6,000 is 0.36 times 6,000, which is 2,160 dollars. Take away her other debts of 500 dollars. That leaves 2,160 minus 500, which is 1,660 dollars for housing.

Now she has two answers, 1,680 and 1,660. The lower one wins, so her top housing cost is 1,660 dollars a month. That covers loan payment, property tax, and insurance together.

Say tax and insurance come to 400 dollars a month on the homes she likes. Then 1,660 minus 400 leaves 1,260 dollars for the loan payment itself.

At a 6.5 percent rate on a 30 year loan, a payment of about 6.32 dollars per month covers each 1,000 dollars borrowed. That factor is a common figure from standard payment tables, and you can confirm it with any loan calculator. So Maria divides 1,260 by 6.32, which gives about 199.4 thousand. She can borrow roughly 199,000 dollars.

If she puts down 30,000 dollars, the price she could reach is 199,000 plus 30,000, or about 229,000 dollars.

Then Maria stops and asks herself the second question. She wants to keep saving 500 dollars a month and travel to see her sister. She decides she would rather spend 1,400 dollars a month on housing. Now 1,400 minus 400 leaves 1,000 for the loan payment. 1,000 divided by 6.32 is about 158.2 thousand. With her 30,000 down, that points to a price near 188,000 dollars.

Two answers, then. The lender says about 229,000. Maria says about 188,000. She chose the second. Good sense.

Where it goes wrong

I have seen smart, kind people trip on the same few stones, and none of it is anything to be ashamed of. The first stone is treating the lender's top number as a goal. It is a ceiling. You do not have to hit your head on it.

The second stone is leaving out the running costs. Repairs, a lawn, a broken water heater, and higher utility bills all come with a bigger house. Many first time buyers count the payment and forget the rest.

The third is spending the whole down payment and having nothing left. A house with no savings behind it is a tight place to live. Keep a cushion after closing.

The fourth is forgetting that some payments change. Property tax can rise. Insurance can rise. If you take an adjustable rate loan, the rate itself can move after the first period ends, so read what the Loan Estimate says about that.

The fifth is shopping only one lender. Rates and fees differ. Asking for several Loan Estimates costs little and can save a good deal. The CFPB has plain guides on this at consumerfinance.gov.

Last, do not pay for a house to impress someone. They are not paying your bills.

Questions to answer before you leave this page

What is your monthly income before tax, and what do you owe each month on cars, cards, and loans? What housing payment, including tax and insurance, would let you keep saving and still enjoy your life? How much cash do you hold for the down payment, the closing costs, and a cushion afterward? Have you asked at least two lenders for a Loan Estimate and compared them line by line? Do you know what your county charges in property tax and what a real insurance quote costs? And when you picture yourself in that house five years from now, are you comfortable, or are you worried?