Becoming a homeowner can mean having a space that's truly yours, building equity over time, and putting down roots for the long term. But before you get your heart set on buying, take the time to make sure that buying a home is the best financial and personal decision for you right now. (Try our rent vs. buy calculator if you're not sure.) Once you feel confident that you're ready to buy, the next decision is how much house will be suitable for your family and your budget.
"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 Shailendra Kumar, a director in Fidelity's Financial Solutions team.
You may be able to avoid this mistake by using these simple guidelines for determining how much house you can afford.
1. Come up with an initial estimate
Using a factor of your household income, you can quickly come up with an initial estimate for how much house you may be able to afford. The total house value should generally be no more than 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 limit that ratio to around 36%–42%. Fidelity's analysis is slightly more conservative, and uses 36% as a maximum advisable 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.
And remember that once you become a homeowner, your mortgage won't be your only ongoing housing expense. You'll also be facing bills for property taxes, insurance, utilities, and maintenance, plus periodic larger expenses like major repairs or upgrades. Depending on where you buy, you may also face ongoing condo or homeowner's association fees.
A more conservative approach is to limit your housing costs to about 30% of your income. Families who pay more than this may have difficulty covering other important expenses. Try this simple calculator to find out how much house you can afford.
2. Save at least your annual salary before buying
Consider holding off on buying until you have saved an amount equal to your household's annual income. This should cover your down payment and the other upfront expenses associated with buying a house. If you purchase a home that is 4 times your annual income, then 1 times your income is 25% of the value of the home. In that case, you would be able to make a 20% down payment and still have money left over to cover closing and moving costs. Consider saving this amount first before making an offer.
Making at least 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 can't put 20% down but still want the big house you've always dreamed of, you could benefit from selecting a nonconforming loan, like an FHA loan. (Learn more about the types of mortgages to consider.)
3. Get preapproved
Of course, the guidelines above are only guidelines. Ultimately, how much house you can afford will depend on how large of a mortgage you qualify for, which in turn depends not only on your income, down payment, and other debts, but also on your credit (plus potentially the credit of your spouse or other co-buyer).
It can be helpful to start checking your credit score and reports regularly even years before you get serious about buying, since it can take time to improve your score (read about tips to improve your credit score). At the very least, consider requesting your credit report from all 3 credit bureaus to make sure there are no errors listed on your report before you begin approaching mortgage lenders.
Once you're ready, consider applying with multiple lenders to try to find the most competitive rate possible. (However, consider submitting all your applications within a 1- to 2-week period, to avoid causing short-term damage to your credit score.) "Always compare all mortgage options available to you, because there might be a better option," says Kumar.
What if you qualify for a larger mortgage than the above analysis would suggest? Remember that it never hurts to keep some wiggle room in your finances. Says Kumar, "just because a bank tells you that you can borrow $300,000 does not mean that you should."