Timing
Remember, just because you can borrow a lot doesn't mean you should.
When figuring out what you can pay for a home, spending no more than a third of your income on housing is a good rule. But it's up to you to decide what feels right. Make sure to plan a budget that's easy on your wallet before you talk to banks or hunt for houses.
First, let’s understand what a mortgage is, the mortgage payment and other costs of home ownership.
Let’s start with the mortgage. Because houses cost so much money, most people need to take out a loan to buy one. This kind of loan is called a mortgage. Any time you borrow money, you sign a written promise to repay the loan, called a promissory note. With a mortgage, which is a secured loan, you make that promise, plus agree to set the house as collateral, meaning you will give the house back to the lender if you don’t make your loan payments.
parts of a mortgage
principal
The amount you have borrowed to purchase the home. This part of the mortgage payment pays off what you borrowed.
interest
The amount the lender is charging you to borrow the money. It is usually a percentage of the amount that was loaned to you. With interest, you repay the lender more than you originally borrowed.
taxes
The tax portion is used to pay property taxes on your home each year. The taxes are based on how much your home and land are worth. Taxes help support public places like schools and libraries and public services like road maintenance and fire stations.
insurance
The insurance portion is used to pay homeowners insurance and sometimes mortgage insurance each year. Your lender requires you to have homeowners insurance in case of a fire or similar event. Your coverage will be based on the value of your home and includes coverage for casualty and liability.
Usually, the lender will figure out the total amount you will owe each year for taxes and insurance and then ask you to pay one-twelfth of that amount each month. The lender puts those funds into a separate "escrow" account. When your tax and insurance bills come due, the lender pays them for you. As taxes and insurance costs may go up over time, the amount your lender collects each month may go up as well.
Not all mortgage loan payments include money for taxes and insurance. Check with your lender. If your monthly payments do not, you will need to save money each month to pay your tax and insurance bills when they are due each year.
$3,500 per month
costs
upfront
Down payment
Your first investment in your home. The lender decides the minimum amount you can pay for your down payment, which usually ranges from 3.5 to 20 percent of the sales price. If you have more money saved, you can make a bigger down payment and reduce the amount you have to pay back each month.
Closing costs
Fees associated with your loan and other costs related to buying a home. Depending on the kind of loan you choose, closing costs can range from two to seven percent of the home’s price. Not all closing costs are paid at the time of your loan closing. You pay some loan fees, like those for your credit report and appraisal, ahead of time.
escrows and prepaids
Things you pay for in advance that cover the initial months’ premiums for taxes and insurance. Lenders use these funds to set up your escrow account. Your lender may also want you to prepay interim interest – that is, interest on the money you’ve borrowed, which covers the days before your loan payments start. For example, if you buy your home on the 15th of the month and your first payment is due on the 1st, you would have to prepay interest for the number of days between the 15th and the 1st.
reserves
Extra funds you have in a savings account to use for an emergency or to fix things. Some lenders require you to have reserves equal to two or three months of your house payment. Even if your lender does not require it, having this kind of savings account for unexpected expenses is a good idea.
moving and transitional costs
Expenses for moving from your existing place to your new home. You might be able to move all of your belongings by yourself, or you might need to hire professional movers. You will also need to budget for utility deposits and lock changes. Other expenses may include new security and safety features, immediate repairs and new appliances, equipment or furniture.
ongoing
utilities
Services that help your house run. When you buy your home, you are responsible for paying all utilities, such as heating oil, gas, electricity, water, sewage and garbage. Check with your real estate professional on what the average costs of these services are for your new home.
ongoing maintenance
Seasonal or annual tasks to keep your home in good working order. When you buy a home, you need to regularly check on and service the appliances and systems, such as heating and plumbing. Be sure to set money aside for regular maintenance.
repairs
Projects that are needed when something goes wrong with your house. When you buy a home, you will be responsible for fixing things when they break. Be sure to set money aside for anticipated and some unexpected expenses.
upgrades and improvements
Optional projects that change your home and potentially add value, such as adding another bedroom or replacing an old kitchen. Before starting a major home improvement job, plan how much you can afford to spend.
Taxes and insurance
Bills you have to pay each year when you don’t have an escrow account because it’s not included in your monthly mortgage payment or you’ve paid your loan off. Without an escrow account, you’ll have to set aside money each month to pay for these bills when they are due.
affordability
How a lender decides what amount to loan you, which will be based on your income, your debts and the lender’s guidelines.
Step one in determining your affordability is to calculate your gross monthly income. Gather your pay stubs and any other documentation to see how much you make before taxes are deducted, and record your gross monthly income on the form. Include all of the money you get each month, like pay from your job and your spouse’s job, occasional work, child support, alimony, retirement benefits, disability payments, government assistance, etc., on the worksheet.
Here are some ways to calculate your gross monthly income based on how you are paid:
Hourly: (gross hourly rate x hours you work in one week x 52 weeks)/ 12 months
Weekly: (gross pay x 52 weeks)/ 12 months
Bi-weekly: (gross pay x 26)/ 12 months
Twice monthly:(gross pay x 24) / 12 months
Monthly: Gross pay
Non-regular pay: Last year's gross pay/ 12 (months)
Download the worksheet to input your income net income and expenses. You’ll use this worksheet to get an idea of what you can afford. Only fill in the yellow highlighted sections.
debts
Lenders set limits on how much your payments can be each month. To do this, they use standard math formulas – called the housing ratio and debt-to-income ratio – which are calculated using your income and debt amounts.
Housing Ratio
(also called the front-end ratio) is used to determine how much of your gross monthly income can be used to make the monthly mortgage payment. Generally, the housing ratio is between 25-33% of your gross monthly income.
Gross monthly income x housing ratio (%) = maximum house payment allowed
Example: $4,000 x 33% = $1,320
Debt-to-income Ratio
(also called the back-end ratio) determines how much of your gross monthly income can be used to make the monthly mortgage payment plus all other existing debt payments, like car loans or credit cards. This ratio is generally between 30% and 43% of your gross monthly income. The maximum amount allowed for a conventional loan is 50%, and 43% for an FHA loan. If you approach those maximum limits your lender may require additional cash reserves in order to approve your loan.
Gross monthly income x debt-to-income ratio (%) = max payment allowed for housing + existing debts
Example
The bottom line is that the more you owe on other things, the less you will have to buy a home. Is there enough of a difference between what you earn and what you owe that you can afford a house payment? Generally, people who have good credit, a steady income, and low debt can comfortably afford to buy a home that is two-and-a-half to three times their annual income.
prequalification
When meeting with a lender, they will ask questions about how much you make and how much you owe. The lender will review your credit and calculate your ratios. A prequalification should not impact your credit. If you’re concerned about pull on your credit, be sure to check with the lender before providing your information.
Based on this information, the lender will help you estimate
How much they are willing to lend to you.
What house price you should be looking at based on the maximum loan amount allowed,
How much of a down payment you will need.
What the monthly payments will be.
Being prequalified is not a guarantee to loan you the money. It simply gives you an estimated price range. There is a separate step, called pre-approval, where you apply for the loan in advance of finding the home, and the lender agrees to give you a loan as long as you buy a house that is within the price limit, is worth at least as much as you borrow and is within a certain period of time.
Worksheet
You don’t have to wait for a lender to get an estimate of how much you can qualify for. Use your worksheet to get a rough idea of how much you can afford to borrow and the price range of the home you can buy based on your current income and debt situation. The worksheet only gives you an estimate, as only a lender can prequalify you for a loan.
1. Refer to your gross monthly income and debt you calculated earlier in this section.
2. To determine your planned housing expenses, start by selecting an interest rate. Visit www.bankrate.com for typical mortgage loan rates in your area.
3. Now, use this mortgage calculator to estimate your planned housing expenses. Pull your estimated property tax rates and insurance costs from tabs 2 and 3 of the worksheet.
4. Play around with different home purchase price amounts to see what you may qualify for. Keep your housing ratio under 31% and debt-to-income ratio under 43%. These are the standard limits for FHA loans. Conventional loan limits are typically 28% housing ratio and 36% DTI.
After you calculate how much you may qualify for, compare that amount with what you think you can afford to pay based on your budget. Would the new mortgage payment be something you are comfortable with? Add the payment to your other monthly bills. Will you have enough extra money each month to cover your wants and needs? If the new monthly payment makes you uncomfortable, consider a less expensive house.
income and expenses
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Your monthly income before any taxes or deductions are taken out.
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Your income after taxes an deductions are taken out.
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Your general living expenses excluding housing, such as groceries utility bills, etc.
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Items such as vehicle payments, credit cards, student loans, etc.
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What you can expect your new house to cost you per month.
need help crunching numbers?
Fill out this form, and we’ll contact you to schedule a time to review this exercise confidentially!
remember
Typically, a housing ratio is up to 28%.
A Debt-to-income ratio is up to 36%.
If your numbers are higher than this, you can still qualify for some loan products, but we would encourage you to speak with your lender and/or a housing counselor to get more information.
If your numbers don't fit, work on increasing your income and lowering your expenses.