Before you start poring over real estate listings, take time for this reality check: How much house can you afford? Here’s how to figure that out.
Debt-to-income ratio: It’s about what you make—and what you owe
For a quick back-of-the-napkin calculation, try tripling what you (and your partner, if you’re buying together) make in a year. For example, if your income totals $100,000 a year, this means you can afford a home worth $300,000.
“The general rule of thumb is that you can purchase a home that costs about three times your annual salary,” says Harrine Freeman, a financial expert and the owner of H.E. Freeman Enterprises.
Income, however, is only half of the picture; you also have to consider your debts. College loans, car loans, and credit card balances can crimp your ability to pay a mortgage, too.
The way to factor in your income and debts is called your debt-to-income ratio, or DTI. To find this magic number, you divide your debt by your income. If, for example, your monthly income is $6,000 and your debt $500, then your DTI is 8.3% ($500/$6,000 = 8.3%).
Add in a mortgage to your debts, and your DTI shifts considerably. A mortgage of $1,500 a month added to the above scenario raises your DTI to 33%.
And that’s OK: Ideally, your DTI should be 36% or less. Some lenders will allow a DTI of up to 43%, but lower is better, because it means you’re less strapped for cash.
How a home affordability calculator can help
Not good with numbers? A home affordability calculator can do these calculations for you. Just punch in your income, debt, even your dream neighborhood, and it will tell you what price of home you can afford.
Keep in mind that this is just a ballpark start: To get a more fine-tuned assessment, contact a lender, who will sit down with you for free, take a look at your finances, and help you figure out how large a home loan you can handle.
“Working with a great mortgage lender will help you determine what you can actually afford, compared to what you think you can afford,” says Phillip Salem, a real estate agent with Triplemint in New York.
So before you get your heart set on a deluxe apartment beyond your financial reach, figure out what’s realistic—and prep your finances so they’re in great shape to make a purchase.