It's absolutely a seller's market right now. 

With a much higher number of people relocating, low inventory, and a shortage of new construction, homes are flying off the market. Even moderate houses are attracting bidding wars. Low mortgage rates are also contributing to the high demand.

It can be an unsettling time to try to buy a home, especially if you’re a first-time homebuyer who can’t take advantage of the market to sell an existing home. 

Many people are finding the perfect home only to see it slip out of their fingers after getting caught in a bidding war and watching it sell for well above the asking price. This makes it challenging to work out just how much home you can actually afford right now. 

So, how can buyers calculate what they can really afford in this market?

Don’t feel like you’re diving into this seller’s market blind. We’re here to help.

Getting Preapproved for a Home Doesn’t Necessarily Mean It’s Affordable

First, let's get this out of the way. Just because a bank has approved you for a certain loan amount does not mean you can actually afford it. The bidding wars and high prices make it unusually tempting to take out the largest allowable loan so you can afford to actually make a competitive bid.

Unfortunately, this is how people end up not being able to make their monthly payments, struggling with which bills to pay, and/or getting underwater on their loans.

Instead of going by what the bank says, do your own budget and work out what monthly payments you’re willing to make, considering other expenses, debt, financial goals, etc. A good mortgage calculator will let you work from that to a loan amount you can afford. 

For some people, this might be their current payment or their current rent. If you’ve been paying rent on time with no issues for a year or two, you can probably comfortably set that as your monthly payment limit.

And, of course, know how much you can afford as a down payment. A down payment of more than 20% on a conventional loan allows you to avoid paying PMI (private mortgage insurance) with your payments and save you money in the long term.

So, here are some tactics for calculating what you can afford.

Get Pre-Qualified for Your Mortgage

In a seller's market, it’s especially important to get pre-approved to know how much you can offer. 

Be upfront with your bank about how much you want your monthly mortgage payments to be. Some realtors refuse to show homes without a preapproval because of the pandemic, although that trend will likely fade, eventually. Preapproval will also tell you what you can bid on a home.

Pro tip: Look for homes below your pre-qualification amount. This will leave more room for your negotiation in a seller's market.

Keep your DTI (debt to income) ratio in mind

Your debt-to-income ratio (DTI) compares your gross monthly income (the amount you make before taxes and deductions are withheld) with how much you pay each month towards any debts you owe.

DTI looks at student loans, credit cards, auto loans, personal loans, and your potential mortgage payment giving expenses such as food, clothing, health or car insurance, and utilities are not included.

How do you calculate debt-to-income ratio?

To calculate your DTI, add up your total monthly payments for bills like:

• Mortgage payments (or your potential payment)
• Credit card payments
• Student loans
• Auto loans
• Personal loans
• Medical bills
• Timeshare payments
• Child support/alimony
  

Once you’ve totaled your monthly debt payments, divide by your monthly gross income. That will give you a decimal number. Multiply that by 100 to reach your percentage. 

For example, if your monthly household income is $6,000, you pay $1,000 on credit cards and student loan debt, and you're looking at homes with a monthly mortgage payment of $2,300, your DTI would be 55 percent.

Add 20% to the Asking Price

Before even looking at a home, add 20% to the asking price. If it's still within your budget, look. If not, then keep looking. In such an extreme seller's market, you will probably need to be willing to pay at least 15% over asking to secure the home.

By allowing this cushion, you will be more certain you can afford the home and are less likely to end up upset because you got outbid. 

Stay firm on your bids, too. No matter how much you want the house, don't fall into the trap of going with an amount that's approved but not affordable. Yes, we are going to harp on this because it is very tempting right now.

Keep this in mind:

Remember, a mortgage loan is only able to cover the cost of the home’s appraisal price. So if the asking price goes above the appraisal or you get caught in a bidding war, this money will have to come out of pocket.

Get a Great Buyer's Real Estate Agent

Even in a more advantageous market, not many buyers choose to buy directly from the seller. In this market, having an experienced agent is crucial. You need a good agent to help you navigate negotiations, advocate for you, and help you deal with auctions.

Choose an agent who has good reviews and a good reputation. Ideally, talk to people who have worked with them before. 

You want an agent who is local to the area you are trying to buy in, if it is different from the one in which you currently live. They will be able to help you find a good deal. For example, they might be able to find you something in a less fashionable, but still nice, neighborhood you hadn't thought of trying.

Tell your agent exactly what you want, your ideal purchase price, and be very clear if you have any actual deal killers. Accurate information will help set your agent up for success.

Do what you can to boost your credit

The concept is simple: the higher your credit score, the better the mortgage rate you'll get.

The lower your interest rate, the lower your monthly mortgage payment is. 

So how much should you save if you have fair to poor credit? There’s no magical or fixed formula that’ll tell you precisely how much you should save for a home, whether your credit score is iffy or spiffy. But we will remind you that the more you're able to put down up front, the more affordable your monthly payments will be, especially if you can avoid paying private mortgage insurance (PMI).

Prepare for Home Sale Contingencies

Finally, you may be able to win a bidding war over somebody who offers more money by offering other considerations. These might include closing earlier and letting the seller rent the home back for a bit while they move. They might include paying more of the closing costs. 

Allowing for this in your budget will help you be secure about affording your home, but can also help you secure your dream home.

However, don’t waive the inspection (this can be dangerous) or the appraisal (this can leave you with an unexpected cash bill). While doing so can often win a bidding war, it won't put you in a good position going forward, especially if the seller isn’t entirely honest.

It’s also now recommended to not write a heartfelt letter to the seller. While some agents say the tactic is a tried and true way to win a bidding war, other agents, following recent guidance from NAR (the National Association of Realtors), won't deliver or accept love letters anymore as they’ve decided that it raises fair housing concerns.