Real Estate Financing and Investing/How Much Can You Afford to Spend for Housing

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An accurate way to determine what kind of house you can afford is to make two basic calculations: How much can you pay each month for the long term expenses of owning a home (e.g., mortgage payments, maintenance and operating expenses, insurance and property taxes)? And, how much cash do you have to spend for the initial costs of the purchase (e.g., the down payment, points and closing costs)?

Many lenders use various rules of thumb to determine a borrower`s housing affordability. They include:

  • 35 Percent Rule of Thumb. A borrower can afford no more than 35 percent of monthly take home pay.

Example:
Your gross annual income is $33,000 per year and take home pay is $2,095 per month. At 35 percent, you could afford a monthly payment of $733. Using this amount, the mortgage rate (variable or fixed), the mortgage term, and a mortgage payment schedule, the lender can determine how much you can qualify for. For example, say, an interest rate of 13 percent and a 30 year term, you could borrow $66,300. Assume that your budget has already provided for property taxes, insurance, and maintenance expenses and you have $20,000 available for a down payment (after point charges and closing costs). You could buy a house that costs about $86,300 ($20,000 + the $66,300 mortgage)

  • Multiple of Gross Earnings Rule. The price should not exceed roughly 2 to 2 1/2 times your family`s gross annual income.

Example:
If your annual gross income is $40,000, the maximum price you could afford would be $80,000 (2 x $40,000) to $100,000 (2.5 x $40,000).

  • Percent of Monthly Gross Income Rule. Your monthly mortgage payment, property taxes and insurance should not exceed 25% to 28% of your family`s monthly gross income, or about 35% for an Federal Housing Administration (FHA) or Veterans Administration (VA) mortgage.

Example:
You and your spouse have gross income of $60,000 ($5,000 a month). Under this rule, your monthly mortgage payment, property taxes and insurance should not exceed $1,250 (25% of $5,000) to $1,400 (28% of $5,000). That means you could qualify for a 30 year fixed rate loan (with 10-20% down) at less than a 12% rate.

  •  Your debt payments on loans of 10 months or longer, including your mortgage, should not exceed 36% of your gross income, 50% for an FHA or VA loan.

Example:
You and your spouse have gross income of $60,000 ($5,000 a month). If you have a monthly debt load of $500 or less, you might look for a $120,000 house with total monthly housing payments of about $1,300, since total debt payments of $1,800 ($1,300 + $500) equals or is close to 36% of $5,000 monthly gross income). That means you could most likely qualify for a 30 year fixed rate loan (with 10-20% down) even if rates hit 12%.