How Much House Can I Afford?





Maybe you are a first-time home buyer and have no idea what you are doing, or maybe you’ve bought a home before, but this time you want to make sure you are being financially savvy in your decisions. Either way, there are so many things that go into buying a house that the overall process can be daunting. But by understanding how to budget for a home, and taking advantage of your local financial services, you can tackle the house-buying world and how it applies to you on an individual level.

The process for buying a house is not going to be the same for everyone. We all have different financial situations, incomes, salaries, bills, debts, expenses, and spending behaviors. We even all have different desires, wants, needs, and hobbies that go into how we spend our income and will therefore also affect our buying options when looking for a home. All of these variables should be carefully weighed and considered as you embark on your home-buying journey.

First let’s go over some key home-buying terms that you will want to be familiar with . . .

Definition of Key Terms

For an even bigger list of terms and definitions that you might need to know when buying a house, see the National Association of Home Builders’ (NAHB) Home Buyer’s Dictionary Page.

The Principal

The price of a home can also be referred to as the principal, especially by mortgage lenders. It refers to the base cost of the home, and does not include interest, fees, or closing costs. Many people use mortgages to pay for their home, meaning you’ll want to figure out how much mortgage you can afford when shopping home prices.

Down Payment

The down payment on a home is whatever the buyer can pay of the total price upfront. The less money put down in the beginning, the higher the interest rate on the mortgage will be, and the more the buyer will have to borrow from a lender. But the more you can put down in the beginning, the less you will have to borrow, and your interest rate will be lower as well. It is always advisable to pay as much for the house upfront as you can.

Homeowner’s Association Fees (HOA)

Some communities will be part of a Homeowner’s Association (HOA). Communities with an HOA are part of a planned community that often comes with communal benefits and amenities, like a pool, or snow ploughing. HOA’s also often come with certain rules for those who live in that community—rules about lawn upkeep and such—so make sure you understand the requirements and benefits of the HOA before committing to a house in their neighborhood.

Property Taxes

Owning a home and property will require you to pay property taxes each year. The percentage you pay in property taxes will depend on the location and value of your home. When looking in different locations for your home be sure to also look into what the property taxes are like in that area.

Mortgage

A mortgage is the loan and payment plan you go on with a lender to eventually pay off your home. Unless you can afford to pay the entire price of the home upfront (100% down payment), you’ll need to take out a mortgage with a lender to help eventually pay off your home through monthly mortgage payments instead of all at once.

Mortgages come with different time periods to pay back the loan. There are 15-year mortgages, 30-year mortgages, and a 5/1 Adjustable Rate Mortgage (ARM).

  • For a 15-year mortgage your payments are going to go up more and more each year and your payments are going to be higher in general. But you’ll pay less interest overall and pay off your mortgage quicker.
  • A 30-year mortgage is going to allow for smaller payments, but in the long run you will pay more in interest, and it will take longer for you to pay off your mortgage.
  • A 5/1 adjustable rate mortgage is another kind of 30-year mortgage, but your interest rate stays the same for the first five years of the loan. After that initial five years, your interest becomes subject to whatever market changes there are for interest rates.
Homeowner’s Insurance

Homeowner’s insurance is insurance for your home. It can protect you when disasters, natural or otherwise, affect your house. It can even cover some of the costs for damages caused by natural disasters or crime. It can also protect your possessions in these same scenarios and help you to replace whatever was lost or stolen. It is not illegal to not have homeowner’s insurance, but many lenders will require it. There are two kinds of homeowner’s insurance:

  • Cash-value coverage will help cover the costs of damages when they occur, but won’t usually be enough to rebuild your home should you need to.
  • Replacement-cost coverage is insurance that will cover the total cost of your house if you should ever need to rebuild it due to disasters. Most advisers will recommend you get this kind of homeowner’s insurance since it covers more.
Private Mortgage Insurance (PMI)

PMI stands for Private Mortgage Insurance. It is a form of insurance that lenders use to reduce their risks when a borrower can’t afford a down payment of at least 20 percent. Your lender will require a PMI when they are lending you more than 80% of your home’s total value. PMI is also a very costly form of insurance, but there are ways to get rid of it later by refinancing.

Interest Rate

Interest rate is a percentage of money added to your loan as payment to the lenders for borrowing a home loan from them. The interest rate you get on your mortgage will be determined based on your credit history and score. Usually the interest rate will be included in your monthly mortgage payments.

Credit History

Your credit history comes from your credit report and shows your history of paying debts and bills. It is meant to show how often you are on time or late in payments and your overall level of responsibility with your finances. Your credit history and score are what lenders will look at when deciding the interest rate they will put on your mortgage.

Credit Score

Your credit score differs from your credit history in that it is an overall score calculated from your credit history to show how much of a credit risk you are for the lenders. Instead of looking at an entire credit report or history, lenders can simply look at this score to get a quick, overall idea of your credit’s well-being.

Gross Income

Gross income refers to your total income before taxes.

Net Income

Net income refers to your total income after taxes. It is also referred to as “take-home pay.”

Understanding Mortgages

When applying for a mortgage, there are four main factors listed below that lenders will consider and that will influence the kind of mortgage and interest rate you can get:

  • Your income
  • Demands on your income, like debts, monthly bills, loans, and other expenses
  • Your credit history
  • Your credit score
Types of Mortgage Lenders

There are also five general categories of lenders that you can get your mortgage from, and each one comes with its own pros and cons.

  • Federal government agency lenders
    • Federal Housing Administration (FHA)
    • US Department of Agriculture (USDA): These mortgages can be for homes in more rural areas. The USDA can also be used to rebuild and rehabilitate old properties that qualify.
    • Department of Veterans Affairs (VA): These mortgages are for veterans. You can even use them to make your home more accessible.
  • State government lenders
  • Nonprofit lenders
  • Local lenders, banks, and credit unions
  • Larger banks and lenders

The 5 Steps of Buying a Home

Step 1: Look at Your Credit Score

When starting the house hunt many people like to begin with the fun part by getting on Zillow and browsing for the perfect home. But you can’t figure out how much house you can afford on Zillow. If you are serious about buying a home, then you should look at your credit score before you start looking for a home. While looking at your credit score you will want to keep your eye out for the following:

  • See where your credit score is at—how good or bad it is.
  • Check your credit report for any errors and have them corrected.
    • Get on this now because if you need to correct your credit report, the changes will take some time, even months, to correct.
  • Look for ways you can better your credit score.
    • Figure out the reasons your credit score is lower than you want and develop plans to fix those issues or habits.
    • Paying down your general debt will also help your credit score.
Step 2: Do Calculations and Budgeting

The big question most people want to know when looking for a home is how much can I afford? There are many methods for figuring out your own budget for buying a home. Which method you choose will depend on what feels most comfortable for you. But in general, financial advisers will tell you to spend 2.5 to 5 times your annual salary on a home. Again, it is ultimately up to you where you decide to land in this range.
Method One: Based on Your Savings
People are generally advised to pay at least a 20% down payment. In order to figure out the amount of house you can afford based on what you have saved for a down payment, use the following equation:

Method Two: Based on Your Annual Income
If you want a quick estimate of the amount you can afford for a house, below is an easy calculation you can do based on your annual income.

Method Three: the 28/36 Rule
The 28/36 rule is a recommendation that your budget has no more than a 28% front-end ratio and a 36% back-end ratio. Lenders will look at both these ratios to decide your mortgage loan, so it is important to understand where you stand according to this ratio because this is how most lenders will decide what you can afford to borrow from them. When budgeting for a home, you can use this ratio to see if you meet these requirements and to see how financially ready you are to buy a home.

  • Front-end refers to your total housing payments (PITI) to income ratio.
  • Your total housing payments is not just referring to the Principal, but also the Interest, Taxes, and Insurance (hence, PITI). This front-end ratio means that you should not spend more than 28% of your monthly gross income on your total monthly mortgage payments.

  • Back-end refers to your total debt to income ratio (DTI).
  • This back-end ratio means that you should not spend more than 36% of your monthly gross income on debts. Debts include credit card payments, child support, auto loans, student loans, and any other debts you may have.

Dave Ramsey’s Advice

Dave Ramsey has influenced and guided a lot of people in their financial affairs with his knowledge. Below is some of his basic advice for buying a home:

  • Pay a 100% down payment in cash when you can.
  • Choose a 15-year mortgage over a 30-year mortgage.
  • Keep your mortgage payments (plus insurance and taxes) no more than 25% of your take-home pay (net income).
    So unlike the 28/36 rule, Dave Ramsey advises that your front-end ratio be no more than 25%, instead of 28 percent. He also advises that you use this percentage on your net income, or take-home pay, rather than your gross income, because this will better reflect the money actually going to your account after taxes.
What to Remember When Budgeting:

The Mortgage:
Just because a lender qualifies you for a certain amount that does not mean you should use it all. How much mortgage you can qualify for is very different from how much mortgage you should use. The maximum loan amount that your lender is willing to let you borrow, does not reflect your personal budget and what you actually want to be paying each month. This is why being able to do your own budgeting and calculations is important because then you can see and decide for yourself how much you are willing to borrow.
The Down Payment:
When preparing to buy a home, what you really want to be doing is preparing for the down payment. The higher a down payment you can afford the better.

Your down payment should be at least 20% of the total price of the house. But, you can find loans that accommodate lower down payments if that’s what you require:

  • Fannie Mae, Freddie Mac, the Federal Housing Administration, the USDA, and the Department of Veterans Affairs are just a few options for low down payment mortgages.

Other Costs and Fees Associated with Buying a Home:

  • Closing costs and fees. Some examples of what may be included in the closing costs are appraisal fees, loan fees, attorney fees, and house inspection fees. Closing costs and fees will vary and depend on local tax laws and the cost of your home. If you want to estimate how much your closing costs might be, they generally range between 2 and 5% of the cost of your home.
  • Taxes, insurance, and HOA fees for certain neighborhoods.
  • Home maintenance, upgrades, and repairs: Homes need regular maintenance, remodeling, normal upkeep over the years, and repairs when emergencies and damages suddenly occur.
  • You’ll need to potentially buy appliances, furniture, and decorations.
  • You’ll be responsible for paying all your utilities, which can include, heat, electricity, water, sewage, trash removal, cable television, and telephone services.

Your Other Financial Goals:
Buying a home is a big financial goal and dream in life, but you probably have other financial hopes and dreams as well. Don’t forget to factor these in as you budget and look for a home. Some of these other goals may include general savings, saving for retirement, buying a new car, raising children, paying for their college, starting a business, vacations, trips, and any other hobbies, interests, or personal endeavors that may also require a place in your budget.
Know Yourself:
It is important to understand the kind of spender you are. This is another reason doing your own budget for your future house is a good idea, because then you can thoroughly be aware of your spending habits and therefore be more realistic when it comes to budgeting in a mortgage as well.

But you also need to be mindful of how you handle debt. For some people, being in a certain amount of debt can be stressful, while others don’t mind it so much. Be aware of whether having a larger mortgage on your hands is going to bother you or negatively impact your internal well-being. This will also factor into what you decide to do financially about budgeting for a mortgage.

You can also hire a personal financer to look over all these factors for you and take a more personal, detailed look into all of the many costs involved for you individually. Hiring a professional may be wise if you do not have the time or patience to look into these variables yourself. It is less wise to rely solely on a lender’s analysis because they will only look at income and credit history, and not consider your personal, bigger picture.

Step 3: Find Your Agent

Buyer’s Agent
A buyer’s agent is the kind of agent you want to be working with directly because they are meant to work with the buyer (you) and will thus work to get you the best price you can get.
Seller’s Agent
This is not who you want to be working with directly because they will be trying to get the best price for the seller. Though usually the buyer and seller agents will mediate offers and agreements and work alongside each other in that way.

Now it’s time for the fun part—the home search! After you’ve done all your budgeting and have all your ducks in a neat, planned-out row, you can begin to search for the home that fits your wants, needs, and budget!

Remember all the budgeting calculations you did above when you are filtering in your price range. It’s recommended to select a price range 10% above and below your calculations as a cushion when you are searching.

What to look for in location:

  • A healthy economy: low unemployment rates and good incomes
  • A good real estate market: look at whether the homes in the neighborhood are selling well, meaning they sell close to or above their asking price.
  • A healthy community: look for a range of ages in the residents and families nearby.
  • A good school district: even if you don’t have children, being in a good school district will help your home retain its value and make selling your home easier should you need to sell later down the road.
Step 5: Enter Your Contract and Close the Deal!

Once you’ve made your choice you can work with your agent to make an offer to the sellers. If all goes through, your agent will draw up the papers and officialize a closing date, which is usually 45 to 60 days after the offer was accepted by the sellers.

When entering into a housing contract you will first want to make sure you have the following common contingencies in your agreement. This means that your contract relies on these personal requirements being met first:

  • obtaining a mortgage
  • getting a home inspection

Buying a home is a big deal and naturally you want to be as knowledgeable and savvy about the basics as possible. By applying these basic rules you will know how to buy a home in the smartest way possible.


READ MORE
Visit the Department of Housing and Urban Development (HUD) for seminars and counseling about buying a home.


Visit the HUD’s common questions page for even more answers to your home-buying questions.


Use an online “How Much House Can I Afford” calculator to plug in your numbers and quickly see how much house you can afford.


Listen to NPR episodes about home-buying to learn more about the home-buying world.


FEATURE IMAGE BY BRENO ASSIS

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