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If you have ever purchased a home or thought about buying a house, you have probably asked yourself, “How much house can I afford”? It can be very tempting to just ask your mortgage lender what you can afford. However, just because your lender qualifies you for a large mortgage does not mean you need to actually finance all that you qualify for.
Planning is one of the most important steps in determining how much house you can afford. There is a big difference between what you are approved for and what you actually can afford. Here are some risks if you choose to buy more house than you can afford:
1. Becoming house poor
I am sure you have heard of this. Being “house poor” is when someone has bought more house than they truly can afford. Their paychecks pretty much go completely towards the mortgage and the housing expenses that they probably did not plan for. Any extra money that was meant for vacations, retirement and entertainment is spent on maintaining the house.
2. Constant money stress
Imagine living with stress everyday as a result of money, or lack of it. Unfortunately, this is the case for many people. If you are responsible for paying for more house than you can afford, your stress will be at an all-time high. All of your money from your paycheck is already spent, and you can only hope that no other big financial situations come up because every dollar is already tied up.
3. Savings problems
Since all of your money is going to maintain your house, you probably will not be able to save for other things like retirement, children’s education or even that dream vacation.
4. Risk of foreclosure
Probably one of the most important things on this list is that if you buy more house than you can afford, you could put yourself at a greater risk of foreclosure. Foreclosure is when you as a homeowner cannot make payments to your lender.
Determine How Much You Can Afford
So before you start looking for houses online or contacting a realtor, you may want to begin by calculating how much house you can actually afford. Here are a few steps you can take which will give you a ballpark idea of how much you really can afford.
1. Figure out your income
When it comes to calculating your household income, start by determining both your gross income and your net income. Gross income is the amount before deductions and net income is the amount after deductions. Lender’s calculations only take into account gross income, but it is also important to know where you stand every month with just your net income.
2. 28% Front-end Rule
If you are not able to buy a house with cash, you will probably have to go through a lender and get a mortgage. When a lender is qualifying you for a mortgage, one of the things they will look at is your debt-to-income.
A lender will start with a 28% front-end rule or ratio which says that your housing costs can be no more than 28% of your gross household income. Your housing expenses will typically include your PITI: monthly principal, interest, taxes and insurance. If you have PMI (Private Mortgage Insurance) or any type of HOA fees, both are also calculated in your total housing expenses.
For example, let’s say you have a gross monthly income of $5,000. You are trying to calculate the max you could qualify for. Take your income of $5,000 and multiply it by 28%. This equals $1,400, which means that your total housing expenses must be under $1,400 per month.
Check with your lender, because every lender has different rules and regulations, but the 28% front-end rule is widely used in the mortgage industry. LendingTree is a great company to start with if you are looking for a lender.
3. Monthly debt payments
Your next step is to figure out your relevant monthly debts that will be factored into seeing how large of a mortgage you qualify for. You may not even have debt, but if you do, your lender will be looking at debts like:
- Car payments
- Credit cards
- Student loans
- Child support
- Other loan payments
Once you figure out all your debts, you can calculate what the minimum is to pay on those debts per month. Even if you pay more than the minimum on certain debts, calculate the minimum in order to get a good picture of what your monthly debt payments are. Your lender will only look at the minimum payments.
4. 36% Back-end Rule
This is the other rule that a potential lender looks at when determining your debt-to-income ratio. In order to figure this out, take your total monthly housing costs and add them to all your monthly debt payments.
The 36% back-end rule says that your total monthly debt cannot exceed 36% of your gross income.
For example, let’s use the same gross monthly income of $5,000. You have total monthly debt payments of $500 per month. Based on the 36% rule, you multiply $5,000 by 36% which equals $1,800. You then subtract the $500 monthly debt payments from $1,800 which leaves you with a maximum housing payment of $1,300.
5. Down payment
Have you started saving for a down payment yet? Your down payment will affect so many things in regards to a mortgage. Depending on your lender, down payments can start as low as 3%.
If you put less than 20% down on a house, your lender will typically require you to carry PMI, also known as Private Mortgage Insurance. Basically, PMI is a way to protect the lender from financial loss if your house happens to be foreclosed or sold for an extremely low price.
If you are able to put down 20%, not only will you avoid PMI, but your total mortgage payments will be significantly lower along with lower upfront fees from your lender. For example, if you are purchasing a home for $200,000, you will need to put down $40,000 in order to avoid PMI.
6. Credit score
Your credit score is an extremely important factor for a lender to not only determine if they can lend you money for a mortgage, but what your interest rate will be set at. Basically, a credit score ranges from 300 – 850 points and many things like outstanding debt, late payments, bankruptcies and many others affect your score. Here is a general idea of what you can expect with your credit scores:
- 750+. You will qualify for the best mortgages, lowest interest rates and lowest fees.
- 680+. You will most likely qualify for mortgages with a decent interest rate and standard fees.
- 620+. You will probably qualify for some mortgages but with higher interest rates and higher fees.
- 580+. You may qualify for a limited amount of mortgages but with the highest interest rates and fees.
- Under 580. You probably will not qualify for a mortgage.
If you have a great credit score, you can expect exceptional rates and the lowest fees. Even if you have an average credit score, you will probably still qualify for a mortgage, but you will have to pay a higher interest rate and fees.
Knowing your credit score will help you narrow down what interest rate you will potentially qualify for. Again, different lenders have different rules, but knowing your credit score will definitely help you prepare for a mortgage. One of the best companies that offers you your free credit score is Credit Karma.
7. Closing Costs
Closing costs are the fees and expenses that are paid with a real estate transaction. This is often a huge cost that is overlooked when you are trying to figure out how much house you can afford. Whether you are paying cash or financing through a lender, you will typically still be responsible for paying closing costs.
The average closing costs for a buyer can range from 2% to 5%. For example, if you purchase a home for $250,000, you can expect closing costs to range anywhere from $5,000 to $12,500.
Here is a list of some of the average type of fees you will see in your closing costs. If you are paying cash for your home, some of these fees will not apply to you.
- Appraisal fee. Fee paid to someone who estimates the current market value of your house.
- Home inspection fee. Fee paid to someone who inspects your home
- Application fee. Fee from your lender to process your request for a loan.
- Loan origination fee. Fee from your lender for evaluating and preparing your loan.
- Document prep fee. Fee paid for preparing your loan documents for processing.
- Credit report fee. Fee paid for having your credit checked and report pulled.
- Title and research fee. Pay this to the title company.
Recurring and One-Time Costs
Once you get a general idea of what you can afford based on money saved to cover your down payment and closing costs, along with your debt-to-income ratio, you can look deeper into what costs will be associated with maintaining your home each month.
1. Loan payments
Your loan will typically last anywhere between 15-30 years, meaning you will be paying your monthly payment faithfully for that long. If you accelerate your mortgage payments, you could have the loan paid off in less time, but you will need to budget to add extra to your monthly payments.
2. Escrow Account
Many lenders allow you to use an escrow account in order to pay your property taxes and homeowners insurance. Property taxes and homeowners insurance are typically paid annually, but by using an escrow account, you are able to pay monthly into an account which is then used to pay taxes and insurance when they are due.
An escrow account is nice because when you make a mortgage payment, it will include your PITI (Monthly principal, interest, taxes and insurance) so you do not have to pay everything separately.
Once your loan is paid off, you typically will pay your property taxes and homeowners insurance annually and no longer use an escrow account.
3. Private Mortgage Insurance (PMI)
Private Mortgage Insurance or PMI is required when you have a down payment less than 20% of your home’s purchase price. Lenders require it to protect themselves against loss in case you stop making your mortgage payments or get foreclosed.
Once you reach 80% of your home’s value, you can ask your lender to cancel your PMI payments. Depending on your lender, they may make you wait until you have 78% of your house’s value.
PMI will typically cost you around .5% to 1% of your entire loan amount. If you have a loan for $250,000, you can expect to pay $1,250 to $2,500 annually or $105 to $208 per month for PMI.
4. Utilities (Gas, Electricity, Water, Trash, Sewer, Internet)
As a homeowner, you will be responsible for paying your utility bills every month or quarter. The cost of utilities will range based on where you live and your monthly consumption. These are very important recurring costs to consider when you are determining just how much you are able to afford each month.
5. Maintenance and repairs
Unfortunately, things inside your home will either need repaired or replaced from time to time. It could be things like a water heater, appliances, HVAC system, furnace, roof and many others.
Many of these repairs can cost thousands of dollars and if you are worried about things breaking all the time, you could consider getting a home warranty. A home warranty helps to cover larger items in the house in case they need repaired or replaced. You can probably expect to pay somewhere in the range of $500 to $700 for a home warranty, but it would give you peace of mind in case something were to break. The only thing you would be responsible for is a small deductible and service call fees. American Home Shield provides some of the best home warranties and can give you peace of mind in case something in your house goes wrong.
6. Improvement and Renovations
As things in your home start getting older and outdated, you may consider wanting to do some updates and renovations. Depending on what you are renovating, your costs can start to add up. Even though your home might not need renovations now, you still should factor future costs into making your decision.
7. HOA Fees
Depending on where you live, you may have to pay a monthly or quarterly homeowners association or HOA Fee. A homeowners association typically covers maintenance and repairs around your neighborhood, along with creating a set of rules and regulations. Your HOA fee helps to cover these costs.
8. Moving Costs
If you are moving across town, your moving costs will be less than someone moving from a different state. You may choose to hire movers or try to do it yourself in order to save money. Moving costs can range from a couple hundred dollars to several thousand dollars. Even though these are one-time costs, you still must plan for this expense. UPack offers free quotes if you are thinking about moving and want a great company to work with.
9. Furnishing
Your new home will probably also need new furnishings. Hopefully you can use some of your old furniture in your new home, but if you cannot, you will have to budget for new or gently used furniture. Remember that furnishings are not just limited to couches, chairs and tables but include many other things.
You may need blinds, window treatments, accent pieces, pictures, bookcases, shelves, rugs, lamps, chairs and many other things. All of these items can add up rather quickly, so you must take into account what you will have to spend on furnishing your house. For our house, we chose to go with Home Depot for all our window treatments, accent pieces and many other things. They were excellent to work with and I highly recommend them.
Summary
As you can see, so much goes into home ownership and preparing to figure out exactly what you can afford when it comes to owning a home. A lender may approve you for a large amount that you can borrow for a house, but there are many other factors that you must also consider. Once you calculate everything, only then can you truly begin looking for a house you can really afford.