Becoming a homeowner may be one of the most exciting and costly responsibilities you’ll assume in your lifetime. And in a high-interest environment, prospective homeowners are shelling out even more for their homes than they have in the past.
According to the Atlanta Fed, housing affordability in December 2022 was worse than at any point in the lead-up to the housing bubble in 2008. As of the final quarter of 2022, the average U.S. home sales price hit $535,800.
Over half a million dollars for a home is a lot of money for most Americans, but what does that look like in a monthly mortgage payment and how do you know if you can actually afford a home at that price point?
Factors your lender will consider
Figuring out whether you can afford a home is a lot more involved than just looking at the home’s sticker price. Your lender will consider a number of different factors when determining how much you can afford to pay for your home and how much they feel comfortable lending. This figure is known as your debt-to-income ratio (DTI).
“The lender will consider all the carrying costs of the new property–including the principal and interest mortgage payment, the property taxes, homeowners insurance, and any homeowner’s association (HOA) fees,” says Sarah Alvarez, Vice President of Mortgage Banking at William Raveis Mortgage. “In addition to this, they will use the information generated on your credit report to determine additional liabilities.”
Your liabilities are any debts you owe that will reduce your spending power and overall net worth. This could include your car payment, student loan debt, credit card debt, or any other lingering balances you may have.
“If you already own other properties, the costs to carry those properties (same as for the new one) are also counted towards your debt to income. Also worth noting is if you pay child support or alimony–even though it won’t show up on the credit report, it is considered a liability and part of the DTI,” says Alvarez.
How much you need to make to afford a $500,000 home
There are several rules and guidelines you can use to determine how much you can comfortably afford to pay for a home.
“This can vary from lender to lender, but assuming you are getting a conforming loan, we are allowed to go up to a 50% debt-to-income ratio (for jumbo or portfolio lenders, that number is typically around 43%) in qualifying a borrower for financing,” says Alvarez. “Using 50% as the DTI for a conforming loan–if you make $120,000 a year–we divide that by 12 to arrive at the monthly income of $10k. From there, we can utilize 50% towards all liabilities and the costs for the new house.”
Using the parameters outlined above, your financial situation might look something like this:
Purchase price: $500,000
Down payment: $100,000 (20% of your home’s purchase price)
Loan amount: $400,000
Interest rate: 6.5% (national average for a 30 year fixed rate mortgage)
Your monthly mortgage payment would be about $2,529, giving you an additional $2,471 each month to cover other housing-related costs like your HOA fees, insurance, and more.
Of course, these figures are highly dependent on mortgage rates (which fluctuate regularly) and your down payment. A change in rates or a higher or lower down payment can significantly impact your monthly payment.
Here’s a look at how a larger down payment could reduce your monthly mortgage payment and potentially make it easier to afford a greater-value home:
View this interactive chart on Fortune.com
If you want to look for ways to free up some of your monthly income, Alvarez says there are ways to lower that cost—especially in a high-interest environment. One way: an adjustable rate mortgage.
An adjustable-rate mortgage begins with a lower initial introductory interest rate and after the promotional period ends, the rate adjusts either on a monthly or yearly basis depending on market fluctuations. The good news: when rates fall, so will your mortgage payment. But homeowners should know that the opposite is true, too.
“Think about taking an adjustable rate or interest-only mortgage, which will help keep monthly payments down prior to being able to refinance when rates come down again,” says Alvarez. “In many ways, higher rate environments can be beneficial for buyers as there is not the same hectic competitive atmosphere surrounding each listing, and you might even find some negotiability in price.”
There’s no hard and fast rule that will tell you exactly how much you can afford to pay for a home. Certain factors like mortgage interest rates, average home prices in your area, your debt balances, credit profile, and more, will all play a role in what your home’s purchase price actually looks like from month to month and whether it fits neatly into your budget or not.
If you’re not sure where to begin or how to set a budget for your home purchase, consider speaking with a mortgage professional who can review your income and your financial circumstances to help you determine how much you can comfortably afford.
This story was originally featured on Fortune.com
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