If you want to purchase a home, you might wonder, “how much house can I afford to buy?” With the mortgage rates still close to its all-time lows and home values still below the peak, this may be a good time to buy.
But how can you tell how much house you can really afford? How do you know that you’re ready for homeownership? As you consider your ability to buy a home, here are some methods that you can use to determine how big a mortgage you can take on:
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Before you even consider buying a home, I believe you should meet the following conditions: You should be able to make a 20% down payment from your savings, and plan to stay in the house for at least 10 years.
A 20% down payment will help you avoid paying Private Mortgage Insurance (PMI). If you can make the 20% down payment from your savings, it shows that you have a healthy positive cash flow (a fact that allowed you to save up the money in the first place). If you do not have the prerequisite savings, you should consider cutting your expenses and increasing your income to save up for the down payment before plunging into homeownership.
The 10 years portion is simply to help increase the likelihood that you will come out financially ahead after factoring in the costs of buying, selling, mortgage payments, and living in your home. If you plan to stay in your house for less than 10 years, consider renting instead.
Photo by nikcname via Flickr
The first rule of thumb is to take your annual gross household income — basically, the money you and your spouse make in a year before taxes — and multiply that by 4. For example, if you earn $40,000 a year and your wife earns $50,000 a year, your household income is $90,000 and you can afford a home that costs up to $360,000 home.
This is a quick way of calculating how much you can afford, but the main problem with this rule is that it doesn’t take into account your other debts.
The second rule of thumb is to keep your monthly housing related expenses (mortgage payment (principal + interest), real estate taxes, and homeowner insurances) to less than 28% of your monthly household income. Using the example above, your monthly income is $90,000 divided by 12, or $7,500 per month. Therefore, your monthly housing expenses should be less than $2,100 ($7,500 x 28%).
Using our mortgage amortization calculator, a $360,000 home with an interest rate of 4% on a 30-year fixed mortgage will cost you about $1,700 a month. This leaves about $400 for property taxes, insurance, and any HOA fee.
The third rule of thumb is similar to the one above, but this rule takes into account all of your debt obligations, including student loan payment, credit card debt payment, and any other debt that you have. From the example above, 36% of $7,500 is $2,700.
This rule is a nice way to double-check your ability to meet your obligations against the other rules. Say you make a $500 car loan payment a month, $250 student loan payment a month, and another $750 payment toward credit card debt. Once you add all that up, you only have $1,200 left for your house payment. This means the $360,000 home is out of you reach.
This is why it is important to limit your amount of debt with respect to your income before adding more debt — such as a mortgage — to your budget.
A second method of determining how much house you can afford is to go directly to the lender and ask for a loan pre-qualification. Many lenders have online applications that you can fill out in less than 10 minutes. After you fill out the pre-qualification application, a representative will call you for additional information and verification. Usually, you will be given the following information:
Also note that this process can result in a hard credit pull and will likely lower your credit score for about 3 months.
I recently went through this process with a lender to see if I would be able to qualify for a loan for an investment property on top of the two mortgages and a car loan that I already have. Here is the process I followed:
The pre-qualification is good for 90 days (they issued a letter via email that I can show to the seller). However, the final loan approval is subject to sufficient proof of income and assets.
Of course, pre-qualification is not a guarantee that you can afford the mortgage payment and other housing costs. One of the reasons that we ended up with a foreclosure crisis is due to overly optimistic pre-qualifications. Don’t think for a minute that just because you were approved for a $500,000 loan that you can afford to repay it.
The problem with all the methods mentioned above is that they do not take your financial habits into account. So what is the best way to answer this question: How much house can I afford?
Personally, I think the best answer is to simulate your home ownership experience. Take your mortgage for a test drive! Say you’re paying $1,300 a month in rent today, and you’re looking at a $1,500 monthly mortgage payment. To be conservative, we’re going to add a 20% premium on top of the mortgage to account for homeowner’s insurance, real estate taxes, PMI, maintenance, and additional utility costs, for a total of $1,800.
It’s easy. Since you’re paying $1,300 in rent, all you have to do is save the $500 difference each month. The best way to do this is to put the money into a separate savings account that pays a decent interest rate. You should do this for at least a few months to see if you can adjust to the new lifestyle.
Buying and owning a home is an exciting experience, but it’s not always the right choice for everyone. For home ownership to be rewarding the house should be both physically and financially comfortable.
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