Everyone’s financial state looks different, but it is important to know as much as possible when it comes to your finances. The more you understand, the easier it is to know where your money goes each month.
One great question we get asked a lot is:
“When buying a home should I use my net income or my gross income to figure out how much I can afford?”
What if we told you the answer is BOTH! Confused? We will explain:
First, let’s break down the difference between net income and gross income.
- Your net salary (or income) is the amount of money you make after federal, state, and local taxes and deductions (such as retirement funds, health benefits, etc.) have been deducted from your paycheck. This is the number that you want to plan your budget around since it is your actual take-home pay.
- Your gross salary (or income) is the total amount of money you make before federal, state, and local taxes and deductions are taken out of your paycheck. This is the number many lenders will look at when they pre-qualify you for how much they think you can afford.
For example, say you make $50,000 a year; This is your gross income. Of that $50,000, you may bring home $1200 a pay period (the time frame you are being paid for); This is your net income.
The number YOU want to focus on to determine how much house you can afford is your net income. If you buy a home solely based on your gross income you could end up being house poor (or not being able to afford anything other than a large house payment). No one wants to live on a super tight budget but so many people fall into this trap!
There are other factors that go into figuring out how much house you can afford such as:
- Your Down Payment: A bigger down payment allows you to borrow less. And when you borrow less, your monthly mortgage payment will be smaller.
- Interest Rates and APR: You shouldn’t focus solely on interest rates when buying a home, but you do need to pay attention to what is included in calculating the Annual Percentage Rate. Many lenders will sneak in added fees into your APR to show you a lower interest rate. This doesn’t save you money in the long run or help your true home affordability.
- Closing Costs: These costs cover important parts of the home buying process such as credit reports, homeowner’s insurance, home inspections and appraisals, title fees, etc. Closing costs vary widely but you should expect to pay anywhere from 2-5% of the home purchase price.*
- Your Debt-to-Income Ratio (DTI): This is the total of all your monthly debt payments (i.e. credit cards, student loans, car payments, etc.) divided by your gross income. It helps you compare how much you owe to how much you earn each month to help you gauge your home affordability.
Now that you know some factors that can help you figure out how much house you can afford, look at your budget. If you don’t have a budget, now’s the time to start one! A budget helps you understand your spending and where your money goes each month.
Spending and income rarely look stay the same all year, so it’s a good idea to make a realistic budget each month.
Once your budget is set, make a plan and figure out how much of your budget you’d like to spend on a house each month. Dave Ramsey suggests spending no more than 25% of your net salary while others will suggest no more than 35% of your net salary. Note: Many lenders will let you go up to 40% or more of your income, so just make sure you work with a Home Loan Specialist who knows your short- and long-term financial goals. Don’t assume because you get approved for a certain loan amount that is what you can really afford.