A common question among new home buyers is “how much home can I afford?” A good question, but a better one, I propose, would be how much home can I easily pay for? This question hits at the heart of the recent real estate meltdown which was fueled, at least in part, by individuals buying homes they would not ordinarily have been able to afford, simply because the bank approved them for it.
The old adage “let the buyer beware” stands especially true in the real estate industry. It’s vital to your financial future that when house hunting, take the view that your decision should be based upon “financial factors first, amenities last.”
Before you even darken the door of a realtor’s office take a hard look at your finances. If you’re struggling to pay rent every month and believe it would be cheaper to own a home of your own, take a closer look at the numbers. Yes, a mortgage may be cheaper than rent, but don’t forget that as a homeowner you are responsible for taxes, homeowners insurance, repairs and in some cases municipal obligations, association fees, etc. which can eat away at any savings you may gain from buying a home, even with its tax advantages.
So, on with the financials...
Figure out how much you can pay. Then decide how much you can easily pay.
Lenders use ratios to determine what you can afford to pay for a home. To follow their example, figure out your debt to income ratio yourself. It’s a handy number to have whether you obtain a mortgage or not. Bankrate.com has a great debt to income ratio calculator to help you with this, as well as other calculators to help calculate interest rates and more.
Front end ratio
This will be shown as a percentage of your gross monthly income. This number reflects what the lender believes you can afford as a loan payment based on your gross monthly income.
Back end ratio
This number is your new mortgage payment plus all recurring debt. For example, if you pay $200 per month on your car and you pay $150 per month on a credit card, the total of $350 plus your new mortgage payment makes up the back end ratio.
Loan programs can vary greatly between lenders, so it’s helpful to enlist the aid of a mortgage broker when shopping for a mortgage because they know the requirements and guidelines of many different lenders. They can shorten your shopping time and potentially save you from getting a loan with less than desirable terms.
Now that you know how much of a mortgage you can likely be approved for, you can work backwards to determine what sales price range you need to focus your search efforts on.
Interest rates will change how much your mortgage payment will be, and those rates change often - daily, and sometimes even hourly. For example, if you want to pay $1,000 monthly principal and interest for a mortgage. A 30 year fixed rate mortgage of 6% will allow you to borrow $170,000 with monthly P&I of $1,1019. Up the interest to 7% and you can only borrow $150,000 with a monthly P&I of $998 monthly, so as you can see, just a difference of 1% can mean a large difference in borrowing power.
As mentioned previously, different lenders will have different underwriting criteria to determine the risk they are willing to undertake by providing you with a mortgage. Part of that criteria is the down payment. Programs range from no money down, a/k/a “100% financing”, to 20% down or more, and a number of factors will determine which ones (if any) you will qualify for.
Any credible real estate professional will advise you to keep a healthy amount in your bank account, especially if it’s your first home. Having a bit of cushion will go a long way to not only making lenders feel more at ease, but can also protect you from going into default within the first year of ownership due to unforseen difficulties, such as a job loss, reduction in your hours, etc.
Expect to pay anywhere from 2 to 3 percent of the sales price for closing costs. So for example a $150,000 home will run you closing costs of about $4500 in addition to your down payment.
Experts recommend that once you’ve determined how much you believe you can afford to pay, set aside the difference between what you’re paying now and what you would be paying as a homeowner, factoring in a set amount for any unforseen home repairs. Think of it as a “dry run” to see how well you do.
If things are too tight, consider eliminating debts and/or opting for a smaller home. Many individuals have started small and worked their way “up the ladder” so to speak of home ownership, buying successively larger homes until settling upon the one they want to live out their years in.
Nothing stays the same forever - things happen, jobs are lost, people get sick, houses catch fire, whatever, so it’s a wise home buyer who plans for such contingencies, allowing plenty of breathing space between what they can afford and what they can easily pay.