Deciding that you want to purchase a home can be an easy choice but figuring out how much house you can afford is where the difficulty arises. First-time home buyers often jump the gun and find their dream home before stopping to consider what they can actually afford in the first place.
Avoid this common mistake when buying a home by crunching the numbers to increase your house-hunting efficiency and configure your financial goal-setting plan.
How much house can I afford with my salary?
You should be able to get a good idea of what you can afford based on your household’s annual income and your debt-to-income ratio, which is all your monthly debt payments divided by your gross monthly income (before taxes). You can calculate your debt-to-income ratio by adding up your total monthly bills, which can include credit cards, student loans, alimony or child support, auto loans and any other loans for which you might be responsible.
After you’ve calculated your debt-to-income ratio, you can quickly gauge how much mortgage lenders will be willing to let you borrow by multiplying your gross monthly income by either 3, 4 or 5 based on how much debt you have. So, if you are completely debt free you can consider homes up to 5 times your total household income. If your debt payments account for less than 20%, homes that are up to 4 times your income may be right for you. If your monthly debt is more than 20% of your income, look for homes that are 3 times your income.
Loan officers generally like to keep your debt-to-income ratio at around 36% including your existing debt and your future monthly mortgage payments.
So, if you have an annual salary of $100,000, have no debt and are approved for a 30-year mortgage with an annual interest rate of 4.25%, you could buy a $500,000 home with a maximum monthly mortgage payment of $3,000. The payment leaves room for a 1.15% property tax and 0.5% for cost of maintenance and improvements.
However, it is important to remember that buying a house for the highest amount you can afford means you’ll have a large mortgage with big monthly payments. Try to keep your housing costs at around 30% of your monthly income.
It is also important to remember that every scenario is different, and every borrower has their own risk tolerance. Your lender will work with you to figure out the optimal solution for your situation.
How much should I save?
Experts say to save an equivalent of your annual income before buying a home. If you’re purchasing a house that is 4 times the amount of your household income, savings equivalent to your salary would account for 25% of the value and would cover a 20% down payment but would also leave you enough for other expenses that come with a new house.
If you provide a 20% down payment, you will avoid extra charges such as private mortgage insurance, which is insurance for the bank that protects the lender if you happen to default on your loan.
However, going with alternative mortgage options such as an FHA loan may be beneficial to you if you have trouble coming up with a down payment of that size. FHA loans are not right for everyone, but they often require homebuyers to only put down 3.5% of the purchase price and are good for people who have thin credit or problems in their payment history.
How does my credit affect my home purchase?
After you’ve determined what your budget is, you’ll want to make sure you have a good credit score so you’re not hit with any unfortunate surprises when trying to get pre-approved by a lender, who will look at how much money you have saved, what your household income is and what your credit score is to determine how much they will let you borrow.
Your credit score will also help determine what kind of interest rates and payment terms you will be approved for. If you have a below-average credit score (which experts say is between 650 and 699), risk-based pricing may be factored into your mortgage details. This means your interest rate may be increased, which could cost you tens of thousands of dollars over the life of your mortgage.
There is no concrete answer as to what credit score you need to purchase a home. However, experts say you may end up with poor loan terms and a high interest rate if you have a score of 660 or lower. For an FHA loan, you’ll need a minimum credit score of 580 to qualify.
Request a free credit report from the 3 credit bureaus and ensure that all the information is accurate and up to date.
What other costs should I consider?
Often overlooked are the extra costs that come with buying a home besides the down payment and monthly mortgage bills. Closing costs will likely cost around 2-5% of the amount of your loan and will include fees such as lender charges, inspections, appraisals and title searches. You’ll also have ongoing payments such as property taxes, homeowner's insurance and any applicable homeowner's association or condo fees.
Maintaining your home comes at a cost, as well. You might have a bigger utility bill than you had before due to an increased square footage, and you may want to pay for weekly or monthly chores such as lawn care.
Make sure not to neglect other priorities such as maintaining an emergency fund for whatever life throws at you, saving for retirement (even if you’re far from retirement age) and a college fund for your kids, if you have them. If you think a mortgage would prevent you from affording everything else, consider renting a little while longer.
After coming up with a game plan on how much you need to save, getting your credit score up to date and setting a budget for your next dream home without overlooking your other financial priorities, you and your family will be in good shape to answer the question, “can we afford to buy a house?”
Visit Door Mortgage if you need more information on just how much you need to save, and happy house hunting!