What you can spend on a home and what you should spend are two very different rodeos. If you’re rollin’ in the dough, by all means, shoot for the stars. If you’re part of the 99% that can’t buy an ocean villa on a whim, what you can spend will likely be decided by your mortgage lender (and their generous nature).
Mortgage lenders are a great tool for wading through the b.s. to find a numerical guideline for how much you can spend. What you should spend follows similar guidelines, but with some added factors.
We got the nitty gritty on determining how much you can and should spend on a home directly from an expert in the mortgage lending arena. While they emphasized the importance of talking to a lender first, they did give us great tips about what to spend on a house. Just make sure you're covered with an affordable home insurance policy.
A Debt-To-Income Ratio That Won’t Leave You House-Broke
Before they start shelling out the big bills, lenders calculate how much they’re willing to loan based on income, debts, assets, etc. They use what is called a debt-to-income ratio and a housing-to-income ratio.
- Debt-to-income ratio: All of your monthly debt payments divided by your gross monthly income. Lenders use this number to determine your ability to manage the payments you make every month. All lenders are different, but debt-to-income ratios can range between 35% and 43%.
- Housing-to-income ratio: The percentage of your monthly income, before taxes, that goes towards housing costs (mortgage, taxes and insurance). Some lenders may aim for 30% of monthly pre-tax income going towards housing, leaving 10% for all other debts. Again, all lenders will use different ratios in determining how much you can spend on a house.
Here’s a quick example: You make $5,000 a month (before taxes). You calculate your monthly debt payments (car loan, school loan, and credit card) and find that you pay $600 a month. Meaning, 12% of your gross monthly income is going towards debts. That leaves anywhere from 23% to 31% of monthly income to go towards housing costs.
To put it simply, the more debt you have, the less money you can spend on a home. However, debt is not the only factor that’s considered in determining how much you can spend. As our expert repeated many times, being qualified for a specific amount doesn’t mean it’s the right amount for you.
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You Should Spend What You Can Afford
A mortgage lender may pre-approve you for a $300,000 home based on current income, debts, etc. Does this mean you should buy a $300,000 home? Probably not, at least if you want to take your kids to Disney next year. You should spend what you can afford without having to compromise on other expenses in your life.
Getting pre-approved by a lender is a good way to determine your budget, but it’s just a tool and not a concrete answer. Maybe you’re planning on going back to school or adding another munchkin. What about retirement? When you’re serious about home buying, consider all current debts, but don’t forget about future plans.
A Realistic Look at Spending on a House
When deciding what you can spend on a house, remember to look at all the factors. Mortgage payments, taxes and insurance are necessary, but you also need to consider the down payment, closing costs, utilities, and renovations. Also, think of any future plans that may crop up in the next five to ten.
It’s easy to crunch numbers and look at rough estimates. However, when the end of the month is near and utilities are due, make sure you can pay them without a second thought. When buying a home, buy within the parameters set by your mortgage lender and yourself. Find out what sort of limits you are working with and then factor in the other variables. And make sure you're covered with an affordable home insurance policy.