How 'What Can I Afford?' Is the Wrong Question
When you start your homebuying journey, it’s easy to start straying away from realistic prices of homes while browsing the many beautiful homes on the market. By realistic, I mean what’s truly realistic for YOU. Sure you may have been approved for a certain amount for your home loan, but does that mean that’s what you can actually afford? Maybe yes, but maybe no. Therefore, asking someone else “What can I afford?” is the wrong question and instead, you should ask yourself “What can I afford that I am comfortable with?” The one who can really answer that question is you, and your family of course. Although you may have been approved for a certain loan amount, that doesn’t mean you have to go all-in. You can borrow up to that amount, but the less you borrow, the less your monthly payment will be.
The difference between what you qualify for and what you can afford
When lenders address what you qualify for, it’s typically determined by your gross income. That means your taxes and deductions haven’t been factored in. But we know that when it comes to budgeting our daily lives, most of us look at our net income – meaning what we take home after all deductions. So even with taxes and other deductions applied, like healthcare for example, you should also start calculating all of your debts (although this is also looked at by lenders) when looking to see what you can afford with what you have left over. Dependents don’t typically play a huge factor in some loan guidelines. Although there are some loan programs, such as a VA Loan, that take the size of your family into consideration. And even if it’s down on paper, only you will really understand how much it takes you to support three kids versus just yourself. Maybe one of the kids gets sick more, or maybe one of them just started a sport that’s a little pricey. It may not be written down on paper, but it still plays a factor in your monthly budgeting. It may not be a consistent monthly expense, but you know you need a certain amount set aside for such instances. These aren’t things that will be taken into account by a lender, but play an important factor in your lifestyle and budget.
Breaking down what a lender can qualify you for
What you may qualify for with a home loan versus what you can actually afford When a lender looks at what you can afford, they first want to know your gross income and if it’s consistent. For salaried jobs, this is simpler to calculate than if you’re a freelancer for example, or working off commission. They then want to calculate all of your debts reflected on your credit report (and any others that you are required to pay, like alimony or child support) so that they can determine your DTI (debt-to-income ratio.)
As a good rule-of-thumb, lenders don’t want your total debt-to-income ratio to exceed 43%.
This means that after taking your total debts and dividing by your gross income, the result needs to be less than 43%. But for budgeting purposes, the standard 50/20/30 budgeting rule is another great way to keep your budgeting top-of-mind.
Figuring out your homebuying budget with what you can afford
For the 50/20/30 rule, you’d want to have 50% of your paycheck go towards your recurring fixed costs, such as rent or future mortgage, car payments, basic groceries, and even monthly subscriptions such as a gym membership. This doesn’t mean that if you have some left over you have to use it on flexible spending. Instead set it aside for any other potential fixed spending that may come your way.
After all, like mentioned previously, you really don’t want to have more than 43% of your income to be debt-related. 43% of that 50% should be spent on necessities. A gym membership for example isn’t a necessity, and you can always be more frugal with your groceries.
For your savings account or even saving for your down payment, you’d want 20% of your income to go towards that. This will help you steadily build your financial ground. And you should still apply 20% for the entire household gross income, so your spouse should also be saving 20% of their income.
Once you have the 50% and 20% figured out and squared away, you can use the rest of the total, which would be the 30% on flexible spending such as dining out, travel, shopping, and hobbies. After all, you need to live a little right? The 50/20/30 rule is just to get you started in thinking about your financial situation and your financial goals. You can always be more conservative with your spending and spend less on debts, while saving more. By understanding your debt-to-income ratio, as well as budgeting by the 50/20/30 rule, you can make a better judgment in regards to what you can truly afford not just by what you were told you were qualified for. So although you may want to know what you qualify for, it’s always best to ask yourself, “What can I afford that I am comfortable with?” At the end of the day, feeling comfortable with your monthly payments will make owning a home that much more of a pleasant experience.