Owning a home is a significant part of the American dream, but in today's real estate market, determining how much house you can afford can be a challenging task. If your annual income stands at $120,000, we're here to help you find the answer. This article will lay out the basic rules and key factors you need to consider to gauge your home affordability.
How Do You Determine How Much House You Can Afford?
Determining how much house you can afford boils down to a straightforward assessment of your gross monthly and annual income, where you take into account two crucial factors:
Monthly Mortgage Payment: You need to calculate how much you'll pay each month as a mortgage. This amount is a fundamental component of your home affordability.
Debt Services and Expenses: Factor in your other financial obligations, such as credit card payments, student loans, and any other monthly expenses.
To quickly calculate whether a house is too expensive for your income, you can follow the 28/36 rule and calculate how much of your monthly income you’ll use for a mortgage payment with it.
What Is the 28/36 Rule?
The 28/36 rule is a widely recognized method for determining the amount of mortgage debt you can comfortably take on without risking your financial stability.
Under this rule, borrowers should adhere to two key limits:
28% for Housing Expenses: Allocate no more than 28% of your gross monthly income to cover all housing-related costs, which encompass mortgage payments, utilities, and other related expenses.
36% for Total Debt Services: Limit your total debt obligations to 36% of your gross monthly income, which includes not only your housing expenses but also other financial obligations like car loans, credit cards, and student loans.
It's important to note that the 36% allocation already incorporates your mortgage payment. The primary purpose of the 28/36 rule is to ensure that the cumulative burden of your housing and debt expenses doesn't excessively strain your income, jeopardizing your financial stability.
Furthermore, the 28/36 rule plays a pivotal role in lending decisions. Many financial institutions and lenders employ this guideline when assessing loan applications. For example, if you're applying for a mortgage and your debts consume 80% of your gross monthly income, the likelihood of approval diminishes significantly.
To determine how much of your monthly income is already committed to these expenses, you must consider both your projected mortgage payments and the anticipated monthly expenditure on debt services. If these commitments leave you with minimal disposable income for essential expenses like food and transportation, lenders may question your ability to meet debt and mortgage obligations, which could impact your loan approval.
An Example of the 28/36 Rule for a $120,000 Annual Income
Let's illustrate the 28/36 rule with an example using a $120,000 annual income, which translates to $10,000 per month. Under the 28/36 rule, your monthly housing expenses should not exceed 28% of your monthly income, which, in this case, would be $2,800. Furthermore, your total debt services, including your mortgage, should not surpass 36% of your monthly income, which amounts to $3,600.
Imagine you find a house priced at $350,000. Upon examining the mortgage terms, you discover that your monthly mortgage payment would be $1,800. When combined with your other monthly debt obligations – a $400 car payment, $500 in student loan payments, and $200 in credit card debt – your total debt services come to $2,900. This amount falls comfortably below the 36% threshold.
Based on the 28/36 rule, you can confidently consider purchasing this house since your combined housing and debt expenses are well within the recommended limits.
It's important to note that as your income increases, your ability to afford a larger, more expensive house also improves. With a proportionately larger income, you can allocate more towards your mortgage payments, allowing you to consider more expensive homes while still staying within the 28/36 rule's guidelines.
What Are Some Other Considerations That Influence How Much House You Can Afford?
While the 28/36 rule is a useful tool, you can also consider other attributes and aspects to determine whether you can or cannot afford a house of a particular price.
The location of a property plays a crucial role in determining real estate prices and, subsequently, your monthly mortgage payments. In expensive real estate markets, you'll need a higher income and lower monthly debts to comfortably make mortgage payments.
The duration of your loan affects both your monthly mortgage payment and the amount you'll pay in interest. Shorter-term loans typically come with higher monthly payments but lower overall interest costs, while long-term loans often have lower monthly payments with higher total interest expenses. The most common type of mortgage in the US is the 30-year fixed-rate mortgage, offering a consistent interest rate over the entire loan term.
The interest rate is a pivotal factor in your home affordability. A higher interest rate means larger monthly interest payments on top of your principal. Different interest rates can result in significant variations in your monthly mortgage expenses.
Your credit score is crucial in the mortgage approval process. Lenders use your credit score to assess your creditworthiness, and a higher score often leads to a lower interest rate on your mortgage. A lower interest rate can make a substantial difference in your monthly payment and overall affordability.
Then there’s the down payment. If you can make a bigger down payment toward your new property, you’ll pay less interest over the loan’s term. Many lenders will also reward you with a lower interest rate if you make a larger down payment.
Conventional loans may require a down payment of 5% to 20% or more, while some other loans require very low down payments of just 3.5% (such as FHA loans for first-time homebuyers). In any case, it’s always wise to make as big of a down payment as possible so you save money in interest payments over the years to come.
What Online Resources Can Help You Determine How Much To Spend?
Even with the above information, you may not still be totally certain how much money you should spend on a property. Fortunately, there are plenty of online resources you can use to determine what you can spend wisely.
For example, you can speak with a mortgage specialist. Mortgage specialists will take a deep dive and comprehensive look at your income and books to determine:
How much house you can afford
What a comfortable monthly mortgage payment will be
Whether you should cancel or pay off other debts before applying for a mortgage
This kind of advice can be highly useful if you want to qualify for the best mortgage possible with the best rates and terms.
You can also use online calculators. Online mortgage calculators allow you to input your income, debts, and other information to roughly determine how much mortgage you can wisely bear, given your current financial situation.
Before you buy any home, it’s a good idea to talk to the mortgage specialist. They will help you fully grasp your financial situation and help you understand how your financial situation will change once you take out a mortgage.
More importantly, they will break down how your finances impact the mortgages you qualify for and will help you explore all your different mortgage options. Many conventional homebuyers and new real estate investors may not realize that they have more mortgage options available than conventional loans backed by Fannie Mae and Freddie Mac.
For instance, you might qualify for a non-QM loan, such as a bank statement loan. This type of instrument can be highly beneficial if you are a freelancer or business owner and know you have enough income to pay for your mortgage but struggle to qualify for a conventional instrument.
The Bottom Line
At the end of the day, if you make $120,000, you could qualify for many different properties in many different areas. But you'll only learn whether a particular mortgage is a good idea by doing a deep dive into your finances and fully understanding how your mortgage payment will add to your monthly debts and bills.
If you don’t know where to start, Vaster can help. Our experienced and knowledgeable loan officers can help you grasp the different mortgage options available to you, plus help connect you to the ideal lender for your needs, whether you want to purchase a primary residence or start your investment portfolio. Contact us today to learn more!