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

Right now, mortgage rates are higher than they’ve been in recent years. Despite that, there’s been little change in home prices, making it feel more challenging to afford a home than it did just a year or two ago.

With current mortgage rates leading to higher monthly payments, you need to think carefully about how much house you can afford before making a purchase.

How Much House Can I Afford?

When determining how much of a house you can afford, the banks will calculate your ideal price range based on how trustworthy you are with a mortgage.

While this number is usually higher than Dave Ramsey would recommend, factors influencing your eventual monthly mortgage payment include the following.

Credit Score

The better your credit, the more favorable terms you can expect from your lenders. This is why cleaning up your credit before you start shopping for a mortgage loan is essential.

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

If there are any errors in your report, you need to dispute them. Also, if there are any delinquent debts, you must get those resolved and have your reports updated.

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

Debt-to-income Ratio

Your debt-to-income (DTI) ratio is a metric that banks use to determine your ability to take on more debt. Banks calculate this by comparing your monthly debt payments to your pre-tax household income.

While Dave Ramsey preaches the 25% number, banks prefer your mortgages, taxes, and insurance to be no more than 28% of your income. They also don’t like your total monthly debt payments, including your mortgage and other debts like car payments or student loan payments, to exceed 36% of your gross monthly income.our debt-to-income (DTI) ratio is a metric that banks use to determine your ability to take on more debt. Banks calculate this by comparing your monthly debt payments to your pre-tax household income.

You can be approved for a larger loan if you have a higher credit score than the typical borrower. But, in general, you can multiply your monthly income by 0.28. Then, that will be the mortgage payment the bank will approve with insurance and taxes.

Other Costs to Consider

You can still do several things to reduce the cost of your first home, but you still might not be able to handle all the costs of homeownership.

The reality is that owning a home comes with other costs. Your mortgage plus interest is not the only consideration when buying real estate. Additional expenses can complicate the answer to the question, “How much of a house can I afford?”

Remember to evaluate these other costs associated with homeownership.

Property Taxes

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

Maintenance and Repairs

You no longer have a landlord who covers the cost of maintenance and repairs on your dwelling. As the homeowner, you are responsible for the expenses associated with keeping up the home and taking care of it.

This can cost more than you might expect.

Homeowners Insurance

For most homebuyers, the home they’re buying is the most valuable thing they’ve ever purchased. It makes sense to want to protect it. Your lender will also want to protect the thing securing your loan, so home insurance is vital.

Prices vary significantly based on where you live and the value of your home.

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. Plus, if your landlord previously paid sewer and garbage collection costs, these are additional expenses.

Homeowners’ Association Fees

If you buy a home located in a homeowners association (HOA), you’ll pay a monthly fee to help cover the HOA’s costs. HOAs are more common when buying a new home and in certain parts of the country.

The amount of money you pay will typically depend on the amenities your HOA provides. HOAs with more amenities will have higher HOA fees than those with fewer offerings.

Closing Costs

Closing costs are an upfront cost you must pay when you get a home loan. These fees are related to the process of applying for and getting a mortgage.

Mortgage lenders do a lot of work when examining your application. The fees compensate the lenders for the cost of originating your home loan.

Typical closing costs include appraisal fees, credit check fees, origination fees, application fees, and mortgage points. They usually total about 2% to 6% of the loan amount.

Private Mortgage Insurance

Depending on your loan program and the size of your down payment, your lender might make you pay for mortgage insurance. Typically, this will apply if you get an FHA or conventional loan and your down payment is less than 20% of the home’s value.

Mortgage insurance premiums typically cost 0.46% to 1.5% of the loan amount each year, adding to your monthly mortgage cost.

Falling home values

When you rent a home, your landlord incurs the cost of a falling property value. However, if you buy, you could find yourself underwater, especially if your down payment is 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 can use special types of loans that make a home more affordable. The two most common options 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 how much you can afford in monthly payments, but it can get you into a house much sooner if you do not have the upfront cash.

How Much of a 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 aim to improve housing for low to moderate-income households in more rural areas.

While the terms are excellent, USDA loans 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 they can qualify for another type of mortgage.

How Much House Can I Afford with a VA Loan?

Department of Veterans Affairs loans are available to active duty or retired service members and their spouses. These loans offer as little as a zero-dollar down payment.

The rates on these loans are competitive with traditional mortgages, and those who qualify can enjoy zero PMI, even 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

While you could use a home affordability calculator to determine how much house you can afford, some general rules of thumb can also help with your initial calculations. These are just generalizations, so your unique situation may require different considerations.

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 worth 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 comprise no more than 28% of your total income on housing-related costs and 36% on all debts (mortgage, credit card payments, car, etc.).

For example, if you have a gross income of $5,000 a month and $600 in debt payments, you can afford up to a $1,200 mortgage.

This can provide more flexibility while considering other debts. With Dave Ramsey, you won’t buy a house until you pay off all your other debts.

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

How Much House Can I Afford Based On My Annual Income?

The more you make, the more you generally can afford when it comes to buying a home. However, your annual income isn’t the best measuring stick when it comes to knowing the price range of the home you can afford.

Your home-buying budget depends more on your financial situation. This includes your other debts, like car loans or credit card debt, your credit score, and market conditions.

For example, if you have good credit and can land a lower interest rate, you can afford a home with a higher purchase price than someone who has to settle for a higher rate.

Similarly, someone offering a larger down payment amount or living in an area with lower annual property taxes could buy a more expensive home while keeping their monthly payment affordable.

Using the rules of thumb that rely on your monthly income and potential housing payment can help you better determine what you can afford.

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

Every lender will look at your DTI ratio. They use this metric to determine the risk involved in lending you money.

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

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

First-Time Homebuyer Programs

If you’ve never bought a home, the process can feel overwhelming. It’s a good idea to look into first-time homebuyer programs in your area.

These programs can help walk you through the home-buying process, from determining your budget to completing your home purchase. They’ll even help with things like creating a budget, choosing a loan term, and estimating your future housing expenses.

Many also offer financial assistance. For example, they may give you grants or low-interest loans to assist with making a down payment or covering closing costs.

Test to Find Out What You Can Afford

Before you buy, having a “test run” with the increased costs of homeownership is a good idea.

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, you will pay an extra $580 for a home. Can you afford that much house?

You can find out with a real savings test. Open a high yield bank account, and put that extra $580 in the account monthly. Do this for at least four months.

Are you having difficulty making the new “payment?” If so, you may need more time to purchase a home. The higher costs may exceed your ability to pay for them.

The Bottom Line

Before you buy a home, ensure you are genuinely ready to handle the costs. Otherwise, you will be house-poor and strain your monthly cash flow, putting you in a worse position than if you continued to rent.