Mortgage rates are at historic lows right now and the inventory is scarce. Few houses and lots of buyers mean that houses are often going for above the asking price. When you getting into bidding wars with other potential buyers, it begs the question: how much house can you afford? How much house is too much?

Conventional wisdom was to limit spending on housing to 25% of your monthly budget. But what does this really mean? How do you factor in other costs that might eat up that housing budget each month?

To learn more about how much mortgage you can really afford, read on.

Start With a Budget

The first step in figuring out how much you can afford is looking at your budget. If you don’t already have one, now is the time to create it.

You’ll need to know your take-home income as well as your fixed expenses each month, such as your car payment, insurance, cell phone bill, student loans, etc. You also need to know how much credit card or personal loan debt you have and what these payments are.

Don’t just look at the past month or two; instead, try to look back over 12 months. Most banks provide online statements, so you can easily get your monthly statement for the past year.

Remember to factor in things like savings and any future expenses you might have. If you are having a child in the next year, for example, think of the costs associated with that, such as medical and hospital expenses, diapers and other supplies, potential childcare costs, and college savings if that is something you choose.

Figure Out Your Down Payment

Historically, most people believed that you couldn’t even think about buying a home until you had a 20% down payment. This isn’t so accurate anymore, as there are many loans out there, such as FHA and VA loans, that require a much lower down payment, sometimes as low as less than 5%.

Now that you have a handle on your budget, it’s time to review your finances once again to figure out how much you have for a down payment. The mortgage type you are considering will dictate this as well. Conventional mortgages will generally require a bigger down payment, but other loans require less (and some even offer a zero down payment.

However, just because you don’t have to out 20% down doesn’t mean that you shouldn’t if you can afford it. The larger the down payment, the lower your monthly costs will be. A larger down payment means a smaller mortgage payment, but it also means that you won’t have to pay private mortgage insurance (PMI). PMI is an insurance policy that protects your mortgage lender if you’re not able to pay your mortgage.

The PMI amount varies but can be up to 1% of the entire loan amount. On average, most people bay between $30 and $70 a month for PMI. While it doesn’t seem like a lot, it adds up over time as you’ll have to pay it until you build up 20% equity in your home.

The 25% Rule

Once you have your budget laid out and know what you can afford for a down payment, it’s time to calculate how much you can really afford. An easy way to do this is the 25% rule. Basically, this rule says that housing (including any maintenance costs) should not cost more than 25% of your budget.

You can also use your debt-to-income (DTI) ratio to figure this out. Your DTI means that your total debt payments, including loans, credit cards, and your mortgage must be no more than 43% of your income.

Don’t Max Out Your Budget

While you might get approved for a much larger mortgage than you expected, you don’t want to max out your budget and end up house poor. This is especially important if you don’t have an emergency fund for unexpected expenses or home repairs. If your budget is maxed out and you are really stretching to make that mortgage payment each month, what will happen if you need an emergency repair that is very costly, such as a new roof, furnace, or air conditioner?

Just because you get approved for a certain amount does not mean that you actually have to spend that much. If you don’t want to have to drastically change your lifestyle to afford your home, be conservative in how much you spend.

Plan for Other Expenses

Your monthly payment includes more than just the mortgage loan. The acronym PITI helps illustrate this. PITI stands for:

• Principal
• Interest
• Taxes
• Insurance

Every month, you’ll pay towards the principal of your loan (the amount that goes towards your principal increases the longer you are paying on the loan), interest, taxes, and insurance. Your taxes and insurance will be held in an escrow account and paid as they are due (usually twice a year for taxes and annually for insurance).

While these drive-up your monthly payment, the nice thing is that you pay a small amount towards them every month and don’t have to worry about a large tax or insurance bill throughout the year. As you are calculating potential mortgage payments, don’t forget to factor in these things, especially if you live in an area with high property taxes or high insurance premiums.

Ready to Apply for a Mortgage?

Now that you know a little more about what to consider when thinking about a mortgage, you can go into the process with a clear vision of what you can and cannot afford. Be honest with yourself about your finances and don’t bite off more than you can chew.

If you’re ready to buy, contact us at the Lindley Group today. Our loan officers are standing by to help you fulfill your dreams of owning a home!