Buying a home can be a once in a lifetime event for some. High earners may be able to afford more than one home, but it doesn’t mean that lenders will keep on approving your loan applications. On the contrary, mortgage lenders use qualification ratios to measure how much money they’re willing to loan to you.
Based on average qualification ratios, there are certain house affordability rules of thumb.
In the real estate market, a common rule of thumb is that lenders calculate how much one can borrow based on the person’s debt-to-income ratio. In other words, the debt-to-income ratio is someone’s total debts compared to their monthly or annual gross income.
Most of the time, lenders consider granting individuals loans if the loan amount is at least 28% of their gross income. Then there are other rules such as rule 32% or rule 40% which are collectively known as the ‘mortgage rules of thumb.’
If your requested loan amount exceeds any of these limits, your application will likely be declined. So if you know these rules, you can do simple math to figure out whether or not you would qualify for a loan for the amount requested. Doing this will help you save time and energy that you otherwise will waste if you wait on the bank to tell you the same thing.
The 28% rule states that you should spend 28% or less of your pre-tax income on your mortgage payments. This percentage includes the amount spent on interest.
For example, if your annual pre-tax income is $200,000, you can afford to spend around $56,000 annually on mortgage payments, which factor in both the loan principal and monthly interest.
Another rule of thumb is the 28% / 36% rule. In this scenario, once you spend 28% on your mortgage payment you may still have an additional 8% of your income to pay on other debts like car payments or student loans.
If your monthly income is $10,000, you can afford to spend $2000 on your mortgage payment and still have $1800 left to pay towards other financial obligations.
It is quiet to use this rule to calculate how much money you can borrow for a home loan.
The 32% rule covers all of your financial obligations, such as mortgage payments, homeowner’s insurance, property taxes, homeowner’s association fees, etc. The key is to ensure the total liability doesn’t exceed 32% per your monthly income.
If you are earning $5,000 per month, all of your mortgage-related expenses must not exceed $1,800.
The 40% rule suggests that all of your loans, including house mortgage, student loan, car insurance, and credit card payments, shouldn’t exceed 40% of your monthly income.
Lenders review your financial status and usually do not grant a loan when all of your outstanding financial obligations exceed 40% of your monthly income. Before applying for the home loan, do some calculations to determine if you even qualify for the loan.
If your monthly income is $5,000, your total monthly debt payments should be $2,000 or less.
The 40% rule is most often used by lenders, although it may fluctuate between 40% and 50% given the lender. Therefore, to help increase your chances of getting the loan, keep your other financial liabilities low.
The 2.5x rule suggests that you only consider homes priced at 2.5 times your gross annual income. However, you’ll need to consider the local market for this rule to work. For example, if the average price of a home in your area is 5 times your average income then you need to have more money saved or you’ll need to make a bigger down payment for this rule to work.
According to this rule, you can apply for a loan amount that’s 3-times your annual income if you pay 20% of your income towards settling existing loans.
If you do not have a large amount of debt to pay down and you spend less than 20% of your monthly income on bills, you may qualify for a home loan that equals up to 4-times your annual income.
If you don’t have significant outstanding financial liabilities, it is wise to save up to 20% for a down payment before applying for a home loan.
It’s rare, but sometimes borrowers qualify for mortgages up to 5-times their annual income. This is usually the case for people who’ve paid off all major loans and are basically debt-free. However, it does not mean you should maximize and get a home loan for that amount. You can still apply for a smaller loan amount if you do not want to pay large mortgage installments.
To figure out how much house you can afford, get a basic understanding of the different rules of thumb for buying a house. Do some calculations on your own before applying for a home loan and crossing your fingers hoping you qualify for enough to get the house you want. Doing some basic calculations based on your annual income will help you avoid wasting precious time looking at houses you can’t afford.
If you feel you do not qualify, work on reducing your debt-to-income ratio so these rules don’t disqualify you.
The most common rule of thumb is the 28/36 rule, which suggests that you should spend no more than 28% of your gross monthly income on housing expenses and no more than 36% on total debt payments (including your mortgage payment).
In addition to your income and debt levels, you should also consider your monthly expenses, savings goals, and other financial obligations when determining how much house you can afford. It’s important to create a budget and consider all of your expenses before making a decision.
Other rules of thumb include the 2.5x income rule (which suggests that you can afford a home that costs 2.5 times your annual income) and the 30% rule (which suggests that you should spend no more than 30% of your income on housing expenses).
While rules of thumb can be helpful, they should not be the sole factor in determining how much house you can afford. You should also consider your personal financial situation, including your income, debts, expenses, and savings goals, and work with a mortgage lender to determine what mortgage options are best for you.
Common mistakes include underestimating the true cost of homeownership (including property taxes, maintenance costs, and other expenses), relying on a single rule of thumb without considering other factors and purchasing a home that is too expensive or outside of your budget.
To prepare to purchase a home, you should work on improving your credit score, saving for a down payment and closing costs, and getting pre-approved for a mortgage. You should also consider working with a financial advisor or mortgage professional to help you determine how much house you can afford and create a plan for achieving your homeownership goals.