Becoming a homeowner for the first time 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—especially with today’s high mortgage rates. (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. For most people and families, the total house value should generally be no more than 3 to 5 times their total annual household income.
This broad range should be suitable for most buyers’ situations, but considering other factors may help guide you to the top, middle, or bottom of that range (and of course, some buyers may find they can afford more or less than that range). Some factors that could guide you to a lower or higher part of that range include your household’s current debt situation, the general level of mortgage rates, and your household’s potential future earnings power.
Your current debt situation is important because 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. Lenders generally like to limit that ratio to around 36%–42%. Fidelity suggests a slightly more conservative approach and limiting debt payments to 36% of your income, if possible. If you already have other debt, such as from student loans, then you may not be able to take on as much new, additional debt as you otherwise would. And remember that when you buy a home, you’ll face ongoing monthly obligations from property taxes, insurance, any condo or homeowners association (HOA) fees, maintenance, and more—not only from your mortgage.
|Consider a lower price range
|Consider a higher price range
|• Debt: More than 20% of your income goes to pay existing debts
• Mortgage rates: Rates are currently high
• Earning power: You do not expect your salary to increase significantly over time
|• Debt: You are debt-free
• Mortgage rates: Rates are currently low
• Earning power: Your salary is likely to increase significantly over time
The current level of mortgage rates also directly impacts affordability because, needless to say, borrowing becomes more expensive at higher rates. Someone who took out a 30-year mortgage for $400,000, at a mortgage rate of 3% would face monthly mortgage payments of just $1,700. Someone borrowing the same amount, for the same term, at a rate of 8% would face a monthly payment of nearly $3,000. This means that when rates are high, you may be able to borrow less before you start to bump up against those limits on debt-to-income.
And finally, your household’s expected earning power may influence whether or not you choose to “stretch” to a home at the top of your current budget. If you’re in a field where large raises are common, then a home that feels like a stretch today could feel more manageable in a few years. On the other hand, if you expect more modest salary increases, you might choose a mortgage payment that you can comfortably afford at your current pay.
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 you begin home shopping in earnest.
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 you’re otherwise in strong financial shape and ready to buy, you might benefit from considering a nonconforming loan, like an FHA loan. (Learn more about the types of mortgages that may be available to you.)
3. Get preapproved
Of course, while the above guidelines are useful in setting your expectations, how much house you can buy will largely depend on how large 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 risking short-term damage to your credit score.) "Always compare all mortgage options available to you, because even small differences in interest rates can impact your total costs over time," says Kumar.
4. Fine-tune your targeted range
Now that you know how much you can borrow, and you have a general idea of how much you should borrow, you can fine-tune the numbers to come up with how much you want to borrow. After all, says Kumar, “just because a bank tells you that you can borrow $500,000 does not mean that you should.”
At this point, it can make sense to draw up a detailed hypothetical budget. Now that you’re preapproved, you should have a realistic sense of what kind of interest rate you may qualify for. And by this stage you are likely getting serious about your search, and so you have a good handle on pricing dynamics in your targeted area.
Consider running the numbers on a few recent listings, at a range of different price points. Look at what your total monthly costs for housing would be at each of these different price points—factoring in your mortgage, property taxes, insurance, utilities, any condo or HOA fees, regular maintenance, plus an estimate for periodic repairs (one guideline is to estimate repairs and maintenance at 0.5% of the home’s value per year).
Consider how much wiggle room would be left in your finances at each of those price points. Life can be unpredictable, and you never want to stretch your finances so tightly that you’d be unable to cope with an unexpected emergency (learn more about how much to save for emergencies).
Also consider the tradeoffs of a lower or higher range. Does going higher in price buy you a bit more square footage or a nicer location, but really you could meet your family’s needs at a lower price point? Or, with home prices so high in many parts of the country, are you finding you’ll need to stretch simply to get into a home at all?
Buying a home can be a stressful process. But getting clear on your price range, household budget, and any compromises you may need to make can only serve to put you in a stronger position. That way, when the right house finally comes along, you’ll feel ready to make your offer with confidence.