Homeownership is practically a part of the American dream. Before you start dreaming of a picket fence, take the time to make sure that buying a home is the best decision for you right now. Once you’re sure that buying is better for you than renting, the next decision is how much house will be suitable for your family and your budget. (Try our rent vs. buy calculatorOpens in a new window if you’re not sure.)
“One big mistake that many first-time homebuyers often make is not factoring the household’s current debt situation into the decision-making process,” says Beau Zhao, a senior associate in Fidelity’s Strategic Advisers, Inc.
You may be able to avoid this mistake by using these simple rules of thumb for determining how much house you can afford.
First: Determine how much house
Using a factor of your household income, you can quickly gauge how much house you can afford. The total house value should be a maximum of 3 to 5 times your total household income, depending on how much debt you currently have.
- If you are completely debt free, congratulations—you can consider houses that are up to 5 times your total household income.
- If less than 20% of your income goes to pay down debt, a home that is around 4 times your income may be suitable.
- If more than 20% of your monthly income goes to pay down existing debts in the household, dial the purchase price to 3 times.
One of the major factors that determines how much house you can afford is your debt-to-income ratio—that is, your monthly debt obligations divided by your monthly income. Generally, lenders like to keep that ratio around 36%–42%. If you have no preexisting debt, a lender might approve a loan that would bring your debt-to-income ratio up to 42%.
We assume 36% as the baseline maximum debt-to-income ratio you can have in the analysis. Because both your existing debts and your future mortgage payments are components of your household debts, the sum of both should not exceed this 36%. Using this metric, we can solve for the suitable home price so that your household has a healthy, manageable debt-to-income ratio.
Be cautious. Buying the biggest home you can afford means you have to obtain a large mortgage. This means sizable monthly payments—which might make it hard to meet your other financial priorities. A good rule of thumb is to hold your housing costs to about 30% of your monthly income. The U.S. Department of Housing and Urban Development considers families who pay more to be “cost burdened”; such families may have difficulty covering other important expenses.
Try this simple calculator to find out how much house you can afford.
Second: Save at least your annual salary before taking any action
Keep saving until you have saved an amount equal to your annual income. This should cover your down payment and the other expenses associated with buying a house. If you purchase a home that is 4 times your annual income, 1 times your income is 25% of the value of the home, accounting for a 20% down payment and other home-buying expenses. Consider saving this amount first before taking any action.
Paying a 20% down payment is the ideal option in most cases, because you can avoid private mortgage insurance and save money in the long run. If you have trouble paying for a 20% down payment but still want the big house you’ve always dreamed of, you could benefit from selecting a nonconforming loan, like an FHA loan.
Note: You don’t have to borrow the full amount a mortgage lender will give you. “Just because a bank tells you that you can borrow $300,000 doesn’t mean that you should,” cautions Zhao. “And always compare all mortgage options available to you, because there might be a better option.”
Read Viewpoints on Fidelity.com: How to pick a mortgage: 5 considerations
The preapproval process
Once you’ve saved enough for a down payment and determined your home-buying budget, it’s time to check your credit before approaching a lender for a preapproval. This is an important step, because you don’t want to have any unwanted surprises from the lender after you find a house you want to buy. It’s always good to know whether your current credit qualifies for a good mortgage beforehand. The lender will evaluate your savings, income, and credit score to roughly determine how much you can borrow.
It’s important to verify that your credit reports from the 3 credit bureaus reflect accurate information and that everything is up to date. Making sure your credit score is as high as possible can help you get a better mortgage rate, and that can save thousands of dollars in the long run.
Other costs to think about
The cost of a home is more than just a down payment and monthly mortgage payments. During the home-buying process, you’ll need an appraisal to verify that the home is worth the price, and you’ll be responsible for closing costs, which may amount to several thousand dollars. Ongoing costs include homeowners insurance, property taxes, and any homeowners association or condo fees.
And then, of course, there are the costs of maintaining and improving your home. Utilities in a house may cost more than the utilities in an apartment because of increased square footage. Plus, that lawn won’t mow itself. Paying for monthly or weekly trims—or a lawnmower—may need to be in your budget.
New homeowners are often surprised by the unexpected costs that come up in the first few months. You want to make sure you have some savings set aside to take care of those expenses.
Don’t forget about all your other priorities, such as saving for retirement and, if you have kids, their college education. If buying a house would put such a crunch on your budget that it would put these goals in jeopardy, you might consider continuing to rent for a while.
Once you’ve reviewed your savings, considered your budget, and factored in your other priorities, you’ll have a much better sense of how much house you can comfortably afford. And finally it’s time for the fun part—shopping for your new home.