The truth is when it comes to a mortgage, what you can buy, and what you can afford are not usually the same thing. For most of us, the wisest way to make sure we buy a house we can afford is to create a budget built around purchasing a home.
The golden rule in home buying is not to buy more house than you can afford. Of course, this will vary widely from person to person. In early 2020 the average cost of a new home in the United States was over $360,000. This, of course, means that many pay well over that while some pay less. No matter where you fall on that continuum buying a house will likely be the single most important purchase you’ll ever make.
The first part of finding out what you can afford is to get a pre-approval letter from the bank.
To learn more about pre-approval letters, go to https://www.investopedia.com/terms/p/preapproval.asp.
However, just because you are pre-approved for a certain amount doesn’t necessarily mean you can afford that amount, and it is possible you could be setting yourself up for financial ruin in the long run.
Creating a budget that will affirm a home purchase requires more than making sure you can afford the monthly payment. You need to figure your debt to income ratio, which can be done by dividing your monthly expenses by your gross income.
On top of that, you need to consider other ongoing costs, which include homeowners insurance, property taxes, maintenance, and repairs. You also need to plan on putting 20% of the home price down as a down payment out of pocket. Otherwise, you will get stuck with yet another cost called private mortgage insurance. The mortgage company requires this insurance if you cannot make the full 20% down payment to protect them should you default on the loan.
To learn more about down payments, go to https://www.investopedia.com/terms/d/down_payment.asp.
When considering buying a home, you should be aware of what’s called the 28% rule. This means your mortgage payment shouldn’t be any more than 28% of your gross income every month. If you are dealing with the FHA (Federal Housing Association), they allow up to 31%. And all your other debts must be put into the formula. This leads us right into the debt to income ratio.
The other very important issue that lenders will look at is your overall debt to income ratio. Here is an example of how to figure this out, if your mortgage payment is $1,000 a month and all your other debts total another $1,000 a month, your overall debt obligation is $2,000. If your overall gross income is $6,000, then your debt to income ratio is 33%. Generally speaking, the absolute highest debt to income ratio any lender will accept is 43%.
Getting pre-approved for a mortgage amount is only the very first part of the home buying process. There are also ongoing costs, including homeowners insurance, property taxes, utilities like water, trash, electricity, and general upkeep and maintenance. Making sure that you have taken into account all of these other factors, as well as making sure you have a clear idea of how much each one will realistically cost, is the only way you can know for sure whether you can genuinely afford any particular home.
Just because the bank approves you for a certain amount doesn’t mean you will actually be able to afford a house that costs that much. The truth is once you begin to add these expenses into the picture, a house that seems affordable on paper can quickly rise out of your range. It’s very easy to go from a $1,500 a month mortgage payment, which will seem reasonable, to another $1,500 a month in related expenses, and now your monthly obligations have doubled.
Earlier, we mentioned down payments. Now let’s drill down on them a little more. Despite what you may have heard, nearly every lender is going to require at least 20% paid out of pocket for a down payment. The truth is, if you are unable to pay the full 20% down payment, there is still a way you can buy a home. In this case, the lender will require you to obtain what is called Private Mortgage Insurance or PMI. Because this insurance’s cost is added to your mortgage payments, the cost of this insurance can easily boost the monthly payment by up to 1% or more. This is another critical issue to consider in figuring out your actual budget for purchasing a home.
For more information on private mortgage insurance, go to https://www.bankrate.com/mortgages/basics-of-private-mortgage-insurance-pmi/.
The main factors that decide how much you will pay in private mortgage insurance include your home’s size, credit score, and the likelihood of your home’s value to appreciate over time. Even if you know you can’t pay the full 20% down payment, put up as much as you can. Even 10% will dramatically reduce your interest and monthly payments over the long term.
Another good way to gauge what you can afford is through the down payment. If you have enough for 20% of one home, but prefer another home where you can only afford a 10% down payment, then your best bet is to go with the first house that allows you to cover the full 20% down. Your interest and payments will work out much better on that one than the more expensive one.
The other issue to take into account are what is referred to as closing costs. These typically run from 2 percent to 5 percent of the overall mortgage cost. Though they are usually expected to be paid out of pocket, many mortgages can work the closing costs into the mortgage itself. On a $200,000 home, you can expect to pay between $4,000 to $10,000 in closing costs, and even if those are worked into the mortgage, they still increase your monthly payments, and you pay interest on that money as well.
The more money that is tagged onto that mortgage, the longer it will take to realize a profit or return on investment (ROI) for your home. The faster you pay down what is owed on the house versus what the house is worth, the quicker you get into equity. This is a state whereby your home is worth MORE than you owe on it. This equity puts you in a much better financial situation and can be used as collateral for another loan, or you can refinance the mortgage and take that equity out in a lump sum cash payment. That equity can be a lifesaver if you get into financial trouble down the road. For many Americans, equity is the only true wealth they will ever obtain. It can also be used as the down payment toward a new home in the future, thus not requiring any ‘out of pocket’ cash while also offering you an opportunity to purchase a new and larger home.
Another important concern is the overall size of the property and the shape the property is in. The truth is that bigger is not always better, and if you are not a handy type person, you don’t need to buy a fixer-upper. You must be honest with yourself about the condition of the house you want to buy as well as the land it sits on. A 3000 square foot driveway will be a real chore to shovel every time it snows. Even though the house looks amazing on the outside, if it requires extensive renovation in every room before one could really live there, that’s a lot of extra time and expense you must take into account.
We mentioned the utility bills earlier, but there are locations and situations where these can end up varying wildly. It is vitally important that you get some idea of how much they will cost, at the very least a ballpark figure, so you can be realistic about what your budget can afford if you purchase the home.
Buying a home is still part of the American dream, but if you don’t take the time to think it through properly and make sure you are purchasing a home you can truly afford, it can quickly turn into a financial nightmare that you may not be able to easily overcome. By taking into account all of the additional costs and other important issues listed here, you should be able to create a realistic home purchasing budget that will quickly and easily let you know if the home you are thinking about buying is a home you can truly afford.