How Much House Can I Afford? 14 Factors to Consider

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If you are considering buying an investment home, it’s important to determine how much house you can afford before making an offer. This will ensure the monthly mortgage payment is affordable and that the deal will be profitable.

Here are several important factors to consider before you make an offer. Be sure to carefully consider all the costs of ownership, such as the monthly payment, to make sure you can make the estimated monthly payments and turn a profit.

1. Income

Whether you are purchasing your first rental home or investing in your third apartment complex, you need to carefully consider your gross monthly income and annual income to make sure the deal will be profitable.

Make sure that the monthly rent you collect will be enough to cover the monthly mortgage payments, property taxes, maintenance, and other expenses. Ideally, you will charge enough each month to cover your expenses and generate monthly cash flow.

2. Loan Type

As a real estate investor, you can finance the purchase of a home with a conventional loan or use hard money. Although government-backed loans, like VA loans and FHA loans, aren’t intended to finance the purchase of investment properties, there are some ways they can be used for this purpose.

FHA loans and VA loans have low down payment and credit score requirements and great interest rates. Each loan has important pros and cons to consider, and it’s important to research each option before applying.

The type of loan you use will impact the cost of borrowing. Although hard money loans allow you to overcome credit challenges and close fast, they usually have significantly higher interest rates and shorter repayment terms than conventional loans. This may mean a higher monthly payment.

3. Loan Term

The length of your loan (the term) is another important factor to consider when determining how much house you can afford. Most houses are financed for 15 to 30 years, although other terms are possible. The longer you finance a house, the less your monthly payments will be.

Longer loan terms will increase the total cost of borrowing. If you buy a $400,000 home and finance it for 30 years at 5% interest, for example, you will pay $373,000 in interest over the life of the loan. If you finance the same loan for 15 years, however, you will only pay $169,000 in interest. You can use a mortgage calculator to help you determine your monthly mortgage payments and see how much interest you will have to pay.

4. Interest Rate

The interest rate you pay on your mortgage will have a big impact on the total cost of borrowing and your monthly payment. Although a one- or two-point rate increase may not sound like much, it could add tens of thousands in interest to your loan, depending on the term.

An important consideration with the interest rate is whether you decide to go with a fixed-rate loan or a variable-rate loan. With a fixed-rate loan, the rate you pay is locked in when the loan is created and won’t change. If the rate decreases sometime in the future, however, you may be able to refinance to save money.

With a variable-rate loan, the rate is usually fixed for an introductory period, which may be up to five years, depending on the lender. After the introductory period, the interest rate fluctuates with the market. Introductory or teaser rates are often lower than fixed-rate loans, an important consideration for those who intend to flip homes.

5. Closing Costs

When considering a home, it isn’t enough to evaluate the price or the monthly payment. You will also need to consider closing costs, which can be a significant expense. Home closing costs are typically 2% to 5% of the selling price. If a home sells for $400,000, for example, the closing costs will be $8,000 to $20,000.

Closing costs are typically paid at closing, and you will need to have enough saved up to cover them. Depending on your lender, you may also be able to roll the closing costs into your mortgage and repay them over time, meaning a higher monthly payment.

You may also be able to negotiate who pays the closing costs. Some motivated sellers may be willing to pay some or all of the closing costs to sweeten the deal. It depends on the current housing market. If you are in a seller’s market, for example, and there are multiple offers on a home, it’s unlikely that the seller will help out with closing costs.

6. Private Mortgage Insurance

Many lenders require borrowers to carry private mortgage insurance (PMI) if they are using conventional loans. Because a conventional loan is not backed by the federal government, lenders may require some borrowers to carry private mortgage insurance in case of a default. PMI protects the lender, not the borrower.

PMI is typically 0.2% to 2% of the loan amount annually. If you buy a $400,000 home, for example, you can expect the PMI to be $800 to $8,000 each year.

Lenders typically only require borrowers to purchase PMI if they are financing more than 80% of the purchase price. If you have a down payment of at least 20%, you may not have to purchase PMI.

7. Down Payment

The amount of your down payment can make a big difference in the total cost of borrowing over the life of your loan. The more you put down up front, the less you will have to borrow. As mentioned, the amount of your down payment will also affect whether you need to purchase PMI.

Making a bigger down payment could also help you obtain financing. A bigger down payment signals to lenders that you will be less likely to default, which may make them more willing to approve a loan.

8. Property Taxes

Property taxes are assessed annually by local authorities. The money is used to pay for local school systems, public services, infrastructure projects, and other things. Property taxes are based on the assessed value of your home—not the market value. The tax rate varies depending on where a home is located.

Before you purchase an investment home, be sure to find out the local property tax rate. You can then plug the information into a home affordability calculator to help you decide if the deal will be profitable or if you need to increase the rent.

9. Debt-to-Income Ratio

The debt-to-income (DTI) ratio is used by lenders when evaluating you for a mortgage loan. It’s a simple comparison of your gross monthly income to your monthly debts. If your DTI ratio is 27%, for example, it means that 27% of your monthly income goes toward paying your monthly debts. 

Your monthly debts may include:

• Car loans
• Personal loans
• Credit card debt
• Home equity loans
• Student loan payments

To calculate the debt-to-income ratio, a monthly debt only includes something that involves financing. Your living expenses, such as groceries, utilities, insurance, and other things, are not included.

The formula for calculating the DTI ratio is:

Monthly debts / monthly gross income

If the total of your monthly debts comes to $1,500, for example, and your monthly gross income is $5,000, your DTI ratio is 30% ($1,500/$5,000). Most lenders consider a good debt-to-income ratio to be 36% or less. If your DTI is higher, you can reduce it by paying down some of your debts before applying for a mortgage loan.

10. Annual Maintenance

Many people buy homes without considering future maintenance expenses, which could be a costly mistake. As a general rule of thumb, you can expect to spend between 3% to 5% of a home’s cost on maintenance each year.

If a home is worth $400,000, for example, annual maintenance costs could be $12,000 to $20,000. This is a significant expense you will have to include when determining how much rent to charge for an investment property.

11. Renovation Costs

If you are looking for a home to fix and flip, it’s important to determine the costs of renovations before making an offer. Be sure to consider the market value of similar homes in the community (comps) to make sure the home and renovation costs won’t exceed what buyers are willing to pay.

It’s rare to find a home for sale that is in perfect condition. Even if you are buying a home to rent, it may still need some work. Be sure to factor in any renovation costs a home will need to make sure you charge enough rent to cover the expenses.

12. HOA Fees

If you are considering a home that is part of a homeowners association (HOA), consider the monthly HOA fee. An HOA is a private organization that makes and enforces rules in a community. It also takes care of certain maintenance issues, like lawn care.

HOA fees will vary depending on the organization. As an investor, remember that the HOA could increase the monthly fee at any time. The HOA could also charge owners a special assessment to replace roofing, siding, or something else. A special assessment could be a significant expense that could cause a negative cash flow situation.

13. Credit Score

Your credit score isn’t just used by lenders for loan approval—it may also influence the interest rate you will pay. Your credit score indicates how well you handled debts in the past, and those with high credit scores are considered less risky. Lenders often reward those with high credit scores with the best rates on their home loans.

14. Insurance

It’s impossible to predict future expenses as a homeowner. A pipe could burst and cause flood damage, you may need a new roof after a heavy storm, or a termite infestation could cause significant damage to your subfloor. If you aren’t prepared, unexpected expenses could cause financial problems.

To protect your investment, having an insurance policy isn’t optional. It will help to ensure your monthly expenses are predictable so you can enjoy steady income.

If you are insuring your personal residence, you will need homeowners insurance. If you are insuring an investment property, however, you will need landlord insurance. Rates will vary depending on the provider, and it’s best to get quotes from several companies before making a decision.

Before You Buy a House

Adding another property to your real estate portfolio is always exciting, but you don’t want to rush into anything. Here are three additional things to consider before you buy a house to make sure the one you select is best for your needs.

Consider the local housing market

Before you buy an investment home, consider the local housing market to make sure there is a strong demand for rentals. You don’t want to buy a home in a community with a poor economy or a high crime rate, which could result in a long vacancy, property damage, or theft.

Also, make sure the property you are considering is close to amenities and good schools. Many people don’t like to travel far for shopping and entertainment, and they also want their children to get the best education possible. The location of the home you are considering could also affect how much rent you can charge.

Prepare for the unexpected

Investment properties can generate substantial rental revenue for you, but they can quickly turn into money sinks if they are vacant for long periods or if your tenants damage them. This means it’s important to prepare for the unexpected.

Before you buy an investment property, be sure to build your savings so you can weather vacancies and pay for repairs. You also want to make sure you have sufficient insurance. Although landlord insurance will protect you for many things, it doesn’t cover everything. Depending on where the property is located, you may also need flood insurance, wildfire insurance, sinkhole insurance, and other coverage.

Create a budget

Having a written budget is a great way to compare your expenses to your monthly rental income. A budget doesn’t have to be anything complicated, and you don’t need special software to make one.

You can create a simple budget on a piece of paper, or you can use software that you probably already have, like a spreadsheet. You can then plug the information into a home affordability calculator to see if the purchase makes financial sense.

The Bottom Line

Determining your housing budget requires careful analysis of your income, expenses, loan type and term, and credit score. If you review these things before buying, it could prevent you from making a bad investment.

As an investor, you want to make sure that your housing expenses leave plenty of room to earn a profit. Whether you will be flipping or renting, it’s also important to make sure you invest in a community where there is a good local economy and a strong demand for housing.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.