Budgeting for a New Home
How much house can I afford?
Buying a house can be exciting. You’ve probably imagined this moment a thousand times: waking up in the comfort of your own bedroom, walking down the hallway into your perfect kitchen, or sitting by the window watching your kids play in a huge backyard.
We get it; you like to dream big. Every home buyer wants to find a house they love, but you should never make a purchase without first considering how it might affect your financial future. It’s important to stay within the bounds of your budget. Otherwise, that dream home could turn quickly turn into a nightmare when you can’t afford the monthly mortgage bills.
There’s a variety of factors that influence whether you can afford a home, and not all of them depend on the mortgage lender. In fact, banks use a different process to determine your maximum loan than you calculate it yourself.
What lenders look at
Almost every lender will look at one thing first: your DTI, or debt-to-income ratio. This means they compare your annual income to your annual debts, which includes credit cards, medical bills, student loans, or any other loans you still owe on.
Most lenders don’t want your total monthly DTI to exceed 36 percent total. So if you already have, say, a $200 monthly credit card debt, and your monthly income is $4000, lenders would assess your current DTI at 5 percent. With these numbers, you’d likely be approved for a $1240 monthly mortgage payment.
Even once your maximum monthly mortgage is set, you still don’t know the home price you can afford. That’s because higher and lower interest rates can change how much of your money actually goes towards paying for the house, and how much goes to the bank.
When a lender reviews your application, credit score is the main determining factor of the interest rate you are given. The credit score you have is dependent on your payment history, length of debt, total amount owed, and types of credit.
A poor score may keep you from getting a loan at all, but if you are able to secure one it will almost certainly mean a higher rate, and in turn a higher mortgage payment. Higher rates also mean you have a lower budget for home price since more of your money goes towards interest.
Reviewing your credit report and working to fix your score before you apply for a loan can help you avoid an undesirable rate.
Larger down payments qualify you for larger loans. Borrowers capable of paying between 10-20% down payment are more attractive to lenders, as they tend to be less of a risk. Although 10% is generally recommended, you can sometimes get away with paying less upfront if your credit score and DTI are otherwise good.
What you should look at
Just because the bank grants you a loan, doesn’t mean you should spend that much. You still have to put in some work and figure out what is best for your specific circumstances. There’s a myriad of other costs you’ll have to deal with other than your mortgage—many of them obligations the bank doesn’t account for when they write up your loan amount. When you spend the maximum loan amount, it takes away the money you have for saving and discretionary spending.
Monthly payments & income
It’s helpful to think in terms of monthly payments rather than net cost. As a rule of thumb, your monthly housing payment shouldn’t exceed 28% of your monthly income. So, if you make 4,000 a month, your monthly payment should be $1,120.
But your mortgage isn’t the only thing that determines your monthly housing payment—there are also things like property taxes, homeowner’s insurance, utilities, and HOA fees. These factors vary based on location and home size, but they will add to the amount you pay each month.
You’ll also want to consider other homeownership costs you can’t always predict—things like repairs or renovations—and ensure you have enough money to set aside in a savings account for when the unexpected pops up.
Other financial obligations
While most experts recommend a 28% monthly payment, that number isn’t always the right choice for everybody. Some may be able to afford a bit more, and others may need to pay less.
Pay attention to your household budget and note other financial obligations you have. Do you have car payments or plan on buying a car in the near future? Are there college tuition payments for you or a child?
At the end of the day, you know yourself best and should be able to gauge how a payment amount will affect other areas of your finances. Once you’ve determined the monthly payment amount you could comfortably make, use a mortgage calculator to determine what mortgage amount that corresponds to.
The higher your down payment is, the smaller your monthly payment will be and the more money you’ll save in the long run. This is because a larger down payment cuts back on the amount you pay in interest.
If you can wait to buy a house, it’s advisable to do so and spend time saving for the down payment. It’ll pay off and put less stress on your finances when you do start making monthly payments. It’ll also help you afford a higher priced house, because of the lower monthly payments.
Closing Costs & Movie in Expenses
Closing costs are usually between 3-4% of your home’s purchase price and are paid upfront with the down payment. On a 250,000 house, 4% is 10,000. Don’t let this price shock you. The higher the closing, the less you’ll have for a down payment, so make sure you save enough money and consider how this will affect your plans ahead of time.
What it all means
With so many factors to consider, it can be helpful to sit down and talk with an agent. A good agent can help shape your plans and inform you about the types of homes within your price range. They’ll also help keep you grounded in the process.
After you have settled on a budget, the best thing you can do going forward is stick to it. The homebuying process can be emotional, especially when you think about the years you’ll spend building your life there, but it’s important not to get so attached to a home that you forget everything else. The implications of overspending could be disastrous and will make every aspect of your financial life harder. Yes, the home buying process is an exciting time, and you should be able to dream a little! Just be sure to keep it real and make smart decisions.