87% of Homebuyers Think They Know How Much Home They Can Afford (But They Really Don't)

Seven years ago, when my husband and I were house hunting, we were sure we knew how much house we could “afford.” However, once we started really looking at the numbers, and comparing costs to our situation, we discovered that we really didn’t have an idea of what we could really afford.

Most Homebuyers Don't Know What They Can Afford

Unfortunately, our experience isn’t unique. A recent survey from Discover Home Loans points out that 87% of homebuyers claim they know how much home they can afford. However, as Discover asked about the specific expenses, it found that, like me, many homebuyers don’t actually have a clear understanding of the cost involved in purchasing a home.

According to the survey’s results, only 59% of prospective homebuyers know how much their down payment will be, and only 52% have run the numbers on their monthly mortgage payment. So, even though homebuyers might have an idea of what they think they can afford, the reality is that they don’t actually know what those expenses will be.

Because your home is likely to be the largest purchase you make in your life, it makes sense to fully understand your options, and have a good handle on exactly what it will cost you, and how much you can truly afford. Let's walk through the process.

How Much Home You Can Afford?

Just coming up with a ballpark figure of how much you think you can afford isn’t going to cut it when you get right down to it. Before you start looking at homes, it makes sense to know exactly what numbers you’re talking about.

Decide on a Down Payment

First of all, you need to figure out what down payment you can offer. Realize that the lender will trace the origin of your down payment. You aren’t generally supposed to borrow the money you use for a down payment. Instead, it should be in the form of a true gift from a close family member, or it should come out of assets that you already have.

Know Down Payment Minimums

If you are getting a loan backed by the FHA, you need at least 3.5% for a down payment. For conventional loans, many lenders like to see 5% or 10% down. If you are building a home, the lender might ask for 20% down. If you only have $10,000 for a down payment that will immediately limit your choices in terms of how much house you can buy. How much the lender requires ultimately depends on your credit, the purchase price, and the purpose of your home purchase (rental property, second home, primary residence, etc.).

Consider the Monthly Payment

You should also consider the monthly mortgage payment, so you can get a realistic view of what to expect in terms of your budget. There are a number of useful mortgage calculator resources online that can help you figure out what you will pay each month, depending on the amount you borrow, the interest rate you pay, and your down payment.

Don't Rely on the 30% Rule

What you can afford depends on your comfort level, and your other obligations. While many experts tout the 30% rule, which says that it’s “affordable” to pay 30% of your income on housing costs, the reality is that this is just a rough starting point. Instead, consider what you can handle. My husband and I like to keep all of our housing expenses (including utilities and taxes) to no more than 25% of our monthly income.

If you have other obligations, such as credit card debt, car loans, and student loans, it might make sense to get a smaller mortgage — or even put off buying a home until you have less debt altogether. If you spend 30% of your income on your mortgage and other housing costs, and another 15% of your income goes toward other debt obligations, you are spending 45% of your monthly income on debt. That starts to get fairly uncomfortable for many budgets.

Get Pre-Approval for a Home Loan

Getting pre-approval is a great way to figure out how much home you can afford, said TJ Freeborn, a mortgage professional at Discover Home Loans.

 “Pre-approvals help you shop for your new home with confidence. They greatly reduce any financing surprises and generally give you a leg up in buyer and seller negotiations,” wrote Freeborn in her guest article for Redfin. “Additionally, many real estate agents who are representing home sellers will want you to be pre-approved so that they know you are a viable buyer.”

To obtain pre-approval, you need to provide your mortgage professional with financial documents including W2s, paycheck stubs and bank statements. These documents will be used by the mortgage professional to verify your income and assets and to run a credit check. Once this review has been completed, your lender will issue you a pre-approval letter that you can share with your real estate agent or seller.

Be Ready for Additional Costs

Another issue that many consumers don’t address when considering home affordability is the fact that there are a number of other costs that come with buying a house. If 52% of homebuyers haven’t determined how much their monthly mortgage payments will be, as suggested by the Discover Home Loans survey, then it’s reasonable to assume that an even greater number hasn’t thought about other costs, including closing costs, taxes, fees, and moving expenses.

Seven years ago, my husband and I were shocked as the price of our home kept climbing. From property taxes to homeowners insurance to the fact that a bigger house meant higher utility bills, we were surprised at the final cost.

As you calculate how much home you can afford, don’t just assume that the story ends with the principal and interest from a mortgage payment. Remember that there are other costs as well, and you need to be ready to handle them.

Bottom Line

If homebuyers want to have a true understanding of home affordability, then they should spend some time early in the process ironing out the numbers. With the help of some simple calculators, and a clear picture of personal finances, anybody can make an informed purchase.

Discover Home Loans has provided me with compensation for my time and efforts on this article. As always, all opinions are 100% my own.