If you feel like you're ready to buy a house, the first question you're likely to ask yourself is "how much can I afford?" Answering that question means taking a look at a number of factors.
Before you snap up that seemingly great buy on a home, learn how to analyze what "affordability" means. You'll need to consider various factors ranging from the debt-to-income (DTI) ratio to mortgage rates.
Determining your debt-to-income ratio (DTI)—more specifically, the front-end DTI—is an important factor in getting a mortgage.
Beyond the property's price tag, a host of other financial and lifestyle considerations should figure into your calculations as to whether you can afford to buy a house.
You should also evaluate the local real estate market, the economic outlook, and the implications of how long you want to stay put.
You'll also need to consider your lifestyle needs, present, and future.
1. Understand Your Debt-to-Income Ratio First
The first and most obvious decision point involves money. If you have sufficient means to purchase a house for cash, then you certainly can afford to buy one now. Even if you can’t pay in cash, most experts would agree that you can afford the purchase if you can qualify for a mortgage on a new home. But how much mortgage can you afford?
The 43% debt-to-income (DTI) ratio standard is generally used by the Federal Housing Administration (FHA) as a guideline for approving mortgages.
2. What Mortgage Lenders Want
You also need to consider the front-end debt-to-income ratio, which calculates your income vis-à-vis the monthly debt you would incur from housing expenses alone, such as mortgage payments and mortgage insurance.
Usually, lenders like that ratio to be no more than 28%. For example, if your income is $4,000 per month, you would have trouble getting approved for $1,720 in monthly housing expenses even if you have no other obligations. For a front-end DTI of 28%, your housing costs should be under $1,120.
3. Can You Afford the Down Payment?
You can buy a home with as little as 3.5% down with an FHA loan, for example, but there are bonuses to coming up with more.5 In addition to the aforementioned avoidance of PMI, a larger down payment also means:
Smaller mortgage payments—for a $200,000 mortgage with a 4% fixed interest rate for a 30-year term, you would pay $955. If your mortgage were $180,000 with a 4% interest rate for a 30-year term, you'd pay $859.
4. The Housing Market
Assuming you have your personal money situation under control, your next consideration is housing-market economics—either in your current locale or the one where you plan to move. A house is an expensive investment. Having the money to make the purchase is great, but it doesn’t answer the question of whether or not the purchase makes sense from a financial perspective.
If you are buying the property on the belief that it will rise in value over time, be sure to factor the cost of interest payments on your mortgage, upgrades to the property, and ongoing or routine maintenance into your calculations.
5. The Economic Outlook
Along those same lines, there are years when real estate prices are depressed and years when they are abnormally high. If prices are so low that it is obvious you are getting a good deal, you can take that as a sign that it might be a good time to make your purchase. In a buyer’s market, depressed prices increase the odds that time will work in your favor and cause your house to appreciate down the road.
It's too soon to tell what will happen to home prices in 2021. But if history repeats itself, we can expect a drop in home prices as a result of the COVID-19 pandemic and its dramatic impact on the economy.
6. Interest Rates
Interest rates, which play a large role in determining the size of a monthly mortgage payment, also have years when they are high and years when they are low. Obviously, lower is better. For example, a 30-year mortgage (360 months) on a $100,000 loan at 3% interest will cost you $422 per month. At a 5% interest rate, it will cost you $537 per month. At 7%, it jumps to $665. So if interest rates are falling, it may be wise to wait before you buy. If they are rising, it makes sense to make your purchase sooner rather than later.
7. Consider Your Lifestyle Needs
Before you practice making mortgage payments, give yourself a little financial elbowroom by subtracting the cost of your most expensive hobby or activity from the payment you calculated. If the balance isn't enough to buy the home of your dreams, you may have to cut back on your fun and games—or start thinking of a less expensive house as your dream home.
8. Selling One Home, Buying Another
If you are selling a home and plan to buy another house, save the proceeds from your current home in a savings account and determine whether or not—after factoring in other necessary expenses like car payments or health insurance—you will be able to afford the mortgage. It is also important to remember that additional funds will have to be allocated for maintenance and utilities. These costs will undoubtedly be higher for larger homes.
9. Do You Plan to Stay?
Affordability should be the number one thing you look for in a home, but it's also best to know how long you are going to want to live there. If not, you could get stuck in a home you can't afford in a city or town you're ready to leave.
If you want to buy a house without a five-year plan, purchase one that is priced much lower than the maximum you can afford. You'll have to be able to afford to take a hit if you have to sell it quickly. Another exception: If you work for a company that buys the houses of relocated employees—one name for this is a guaranteed buyout option.
10. The Bottom Line
Are you ready to buy a house? In short, yes—if you can afford to do it. But "afford" isn't as simple as what's in your bank account right now. A host of other financial and lifestyle considerations should figure into your calculations.
When you factor in all these elements, "if you can afford to do it" starts looking more complicated than it first appears to be. But considering them now can prevent costly mistakes and financial problems later. Of course, there is one best time to pounce: When you find the perfect house in the perfect place for sale—at a perfect price.
This article was originally published by Reyna Gobel for Investopedia