Home Buying: What can you afford?

Figuring out how much you can afford when looking at buying a home is the very first step you should take in the purchase process.

You might be tempted to just start looking online for your dream home or cruising through desirable neighborhoods to try to spot “For Sale” signs, but all that might be in vain if you do not know your price point. Find out how much you can afford when buying a home by first checking your own finances. From there, it is time to talk to the professionals to see where you stand on a potential loan. Finally, you need to try to evaluate the other costs involved to make sure you can cover everything without wiping out all of your savings.

Check Your Own Finances: The Credit Score

Before you head to the bank to find out about loan options, you should evaluate your own financial situation to see if there are any problem areas you can resolve first. Start by looking at your credit score. Lenders will look at your current credit score as well as your credit history to determine your capabilities in repaying such a large loan. If you see any issues with your credit score, now is the time to resolve them. That could include unpaid accounts or mistakes for old, paid or settled debts. Make sure you pay off balances and make all your payments on time. You might be able to improve your credit score within a few short months if you plan ahead and monitor your finances well. Also, keep in mind that applying for additional credit while trying to buy a home can affect your mortgage. Getting pre-approved and then getting a new car loan, for example, might result in your pre-approval needing to be recalculated altogether. It is best to wait until the home purchase is complete for any new credit cards or loans.

Your Debt-to-Income Ratio

Lenders will evaluate your debt-to-income ratio, which should generally be below 36 percent of your gross monthly income. That debt will include any housing expenses, car loans, credit card debt, student loan debt and more. You can evaluate your own by checking all your current accounts and ensuring you are on track with payments to look more appealing to lenders.

You should also track your monthly expenses for a few months to monitor your own spending on a realistic scale. Track where your money goes so you can make sure to put yourself in the best position possible when evaluating how much house you can afford.

You will need to save between 3 and 20 percent for a down payment, depending on your circumstances and loan options. Make sure you are prepared to not only put that money down, but to still have enough savings to cover all the other costs associated with the home purchase plus homeownership.

What You Can Afford, According to Lenders

After you evaluate your own financial situation, the next step is to speak to the professionals about getting a loan. When lenders look at your financial options to evaluate your potential as a candidate, they will use a standard set of rules to determine your monthly payment capacity.

First, there is the rule of 28, which means that your monthly housing expenses should not exceed 28 percent of your gross monthly income (which can be combined for a couple). That rule is called the front-end ratio. The back-end ratio takes into account any debt you might have, including credit cards, car loans and housing expenses. This amount should not exceed 36 percent of your gross monthly income, but some lenders will stretch this up to even 45 percent or higher. Know that a higher percentage comes with a higher risk. Certain loans, like an FHA loan for example, will cap your monthly payment at 31 percent, with certain exceptions allowed. Conventional loans tend to stick toward the rule of 28.

Mortgages 101

You might have used a student loan to get through college, you might have a car loan that you are paying off each month and you might have or have had credit card debt at some point in time. These are all loans offered to you that you pay back on a monthly basis, usually with interest added. Buying a home follows the same principals. A bank will typically offer you a mortgage loan, which will enable you to purchase a home with a down payment and slowly pay off the house over a, typically, 15-year or 30-year mortgage period.

Some qualified first-time homebuyers might qualify for grants, which do not need to be repaid and do not accrue interest. They can sometimes still be called loans, but after a certain number of years, they are often forgiven. Be sure to research potential grant opportunities both locally and nationally when you start your home search, as the federal government offers various affordable housing options that might help you.

When you start your home search, you will want to be pre-approved for a loan. Getting pre-qualified for a loan is not the same as getting pre-approved; a pre-approval involves more than just checking your credit score. To get pre-approved for a loan, the lender will verify your income documentation and can authorize a pre-approval amount that you can take to a seller as proof. Be sure you are pre-approved for a loan before jumping into the home search process. Without being pre-approved for a specific loan amount, how do you know what you can afford while searching for a new home?

Closing Costs

Being approved for a mortgage and finding your dream home is all very exciting, but it is important that you do not forget about those closing costs. When you purchase a new home, several additional payments will be due to all the professionals involved in the purchase and for other one-time fees. Those might include mortgage taxes, attorney’s fees, title insurance, recording fees for your deed, lender application fees and maybe even property tax reimbursements if the seller has paid in advance. You should plan for up to 5 percent of the total cost of the home purchase for these one-time payments, but you could get lucky with only about 2 percent needed at the end of closing.

Other Homeownership Costs

It is not just about the initial purchase when it comes to your overall expenses for being a homeowner. There are many other costs beyond your monthly mortgage payment that you will have to consider. Owning a home is not like renting, where you can pay your rent to a landlord and request that everything be fixed for free.

Homeowners in the U.S. can estimate a national average of approximately $9,000 for owning and maintaining a home each year, which includes other costs involved like property taxes, homeowners insurance, homeowners’ association (HOA) fees and general maintenance costs. If you are handy, then you might be able to cut some costs. For example, if you maintain your own HVAC system or if you choose not to pay for lawn care all year, you can cut some costs. Otherwise, that national average can help you plan ahead for real numbers. Homeowners’ associations can offer take over those maintenance issues like gardening, lawn care, snow removal and other common necessities. However, you will pay a monthly fee to ensure those costs are covered within your neighborhood and, if major repairs or issues arise, those costs can increase suddenly.

When looking at a townhouse or a condominium that includes an HOA, your lender might even charge you higher rates. Another consideration with condominium fees or HOA fees is your taxes. While a mortgage is tax-deductible, your condominium or HOA fees are not. You could potentially put those additional monthly payments into a larger monthly mortgage for a single-family home, enjoying tax deductions on the larger total.

Another increased cost consideration as a homeowner will be your utilities costs, which could vary greatly from whatever rental utilities you might have previously paid. That increase could logically stem from owning a larger space in a home versus a smaller rental space, which can dramatically increase monthly expenses for utilities.

Alternatively, those higher monthly costs could stem from an old boiler, for instance, or the fact that your old apartment building used solar panels for hot water and electricity, while your new home does not. The installation of solar panels can be a great long-term investment, but it will certainly add to your up-front costs if you take on that project right away. When figuring out how much you can afford for a house purchase, make sure you take everything into consideration so there are no surprises at the end of the day. If you feel prepared, then it is time to find that dream home!

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