Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to firstname.lastname@example.org.
Question from Skylar in Yuma AZ: Good day Brian, I think I’m ready to upgrade to a better home and neighborhood. After eight years, I have about $39,000 of equity in my first home. My income has slightly outpaced inflation since I bought my first home. Ideally, my next house will be a big improvement but won’t put me in the poor house. When I bought my first house, it was a challenge to make the payments for the first two years. I’ve gotten to like having more discretionary income for the past few years. How large of a mortgage should I consider without stretching my budget too far? I’m willing to stretch it a little but not too much.
Answer: Hello Skylar. The good news is that using the approach that you mentioned should mean that you won’t have any trouble qualifying for a bigger home. That’s assuming your credit rating is in good shape because the other major qualifying criteria are your debt-to-income ratio and down payment. Not stretching your budget should keep you well within the debt-to-income ratio and the $39,000 in equity will go along way towards the down payment. But plan on using about 10% of your equity to cover both your selling and buying closing costs. That means for a down payment, you can plan on about $35,000 of your equity.
However, that $35,000 in equity probably won’t buy as much house as you first think if you don’t want to stretch your budget. Without considering everything involved, it’s natural to think that you can simply apply all of the equity towards another home and keep your mortgage payments close to what they are right now. There is a chance that will happen if today’s historically low interest rates are significantly lower than the interest rate on your current home. Interest rates are one important factor in your new mortgage payment but there are several other factors to consider.
Skylar, I suggest that you sit down and calculate all of the costs that are involved in purchasing a better home. Even if you maintain your monthly mortgage payment very close to what you are currently paying, other costs will still go up based on the higher value of your next home. The other important higher costs to consider are homeowner’s insurance, private mortgage insurance, homeowner association fees, and property taxes.
Skylar, because I don’t know what you consider a reasonable amount to stretch your currently comfortable budget, I suggest that you start with the standard mortgage qualifying debt-to-income ratios. First, figure out how much higher of a mortgage payment you can qualify for based on these three ratios:
Skylar, you can reasonably estimate the increase for additional homeowner’s insurance by asking your current insurance agent. Property taxes are a percentage of the assessed home value. The percentage might be the same as you are currently paying or you might need to look it up for the county or neighborhood that you are thinking about buying in. It’s possible that you won’t pay private mortgage insurance but that will be based on the percentage of your down payment for the new house. Conventional private mortgage insurance is calculated based on your down payment and credit score. You can talk to a mortgage broker to get an accurate estimate for private mortgage insurance. Homeowner association fees are very specific to the neighborhood. You can begin talking with real estate agents to get an idea of what these fees cost in the neighborhoods that you are considering.
That might seem like a lot of work to gather the needed information but it shouldn’t take more than a few phone calls. Once you have the right information, you can run it through the same debt-to-income ratios. After that, you’ll be ready to determine how much you want to stretch your budget to buy a better home. For instance, using the Rule of 40, you can calculate how much mortgage (and other necessary costs) you will qualify for. Now, lower the mortgage and other costs so that you are at 30% instead of 40%. That leaves a minimum of 10% of your income as discretionary. Of course, it doesn’t have to be 30%. It could be 25% or whatever number you decide you are most comfortable with.
Don’t forget that the Rule of 40 or 40% doesn’t include other non-discretionary costs such as your utilities, food, clothing, and payroll taxes.
What else do you think should go into a realistic home cost calculation? Please comment.
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