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how to determine how much home you can afford

How to determine how much home you can afford

January 26, 2018 — Written by Paula Pant

Buying a home is one of the most exciting and important decisions you’ll make. But your home is more than just a place to create memories. It will also make a massive impact in your financial life.

In this article, we’ll share some recommendations for determining how much home you can afford so you can sleep comfortably and worry-free in your new abode.

Income, debt, and the 28/36 rule

Let’s break this into two questions: how much home could you qualify to purchase, and how much home do you actually want to purchase?

To answer the first question, let’s look at how large a mortgage you could qualify to borrow.

One good rule-of-thumb is the 28/36 rule, as the Motley Fool notes. Many lenders use this as a guideline when they’re qualifying mortgage applicants. This guideline suggests that your total housing expenses should consume no more than 28 percent of your gross monthly income, and your total debt payments should consume no more than 36 percent of your income.

The 28 percent portion is also called the “front-end ratio.” This ratio looks at your total housing expenses as a proportion of your income. This includes the four components of your mortgage: the principal, interest, property taxes and homeowner’s insurance. These are collectively known as PITI.

Total housing expenses also include your monthly primary mortgage insurance (PMI) or mortgage insurance premium (MIP) payment, which generally applies if your down payment is less than 20 percent. Any homeowner’s association dues or supplemental insurance, like flood insurance, are also included in your total housing expenses.

For example, let’s assume that you purchase a $250,000 home with a 20 percent down payment. The seller covers closing costs. You borrow $200,000 at a 4 percent fixed-rate, 30-year mortgage. You pay the national average in property tax, as noted by CNBC, $180 per month, and homeowner’s insurance, $80 per month. You don’t have HOA dues.

In this scenario, your monthly total housing payments would be:

  • Principal and interest: $954.83
  • Taxes: $180
  • Insurance: $80
  • Total housing expenses: $1,214.83

According to the 28/36 rule, you’d need to earn at least $4,338.68 per month, or approximately $52,000 a year, before taxes, to qualify for this mortgage. This would keep your total housing payments at 28 percent of your pre-tax income.

Next, let’s look at the 36 percent portion of this rule, which is also called the “back-end ratio.” This ratio looks at your total monthly obligations as a proportion of your income.

The combined total of all your debt payments, including your mortgage, student loans, car loans, and the minimum payments due on your credit card, shouldn’t exceed 36 percent of your pretax monthly income. Any child support or alimony payments count toward the 36 percent.

Using the same example as above, if your income is $4,338 per month, your total monthly obligations can’t exceed $1,561 per month. If you’re interested in buying a home that’ll cost $1,214 per month, then your other debts and obligations can’t cost more than $347 per month.

But what if you have massive student loan payments or massive credit card debt? If your existing debts and obligations are high, then the maximum amount that many lenders will allow you to borrow would adjust to keep that back-end ratio at no more than 36 percent.

Credit and closing costs

Several other factors will also impact how much home you can buy.

First, your credit history will impact your mortgage interest rate. If your credit is damaged, you might have to pay a higher interest rate. This means a greater percentage of your monthly payment would be applied towards interest, rather than principal. As a result, you’d need to buy a less-expensive home than you otherwise could have purchased so you can cover the increased interest on top of the amount you borrowed.

Furthermore, some lenders will demand upfront “points,” or fees, for borrowers with tarnished credit. Points are upfront fees paid directly to the lender at closing. There are two types of points: “discount points,” in which you buy down the interest rate on your mortgage, and “origination points,” in which you pay the lender for the cost of making the loan.

If you have tarnished credit, and particularly if you have a hard time obtaining conventional financing, your lender may require you to pay origination points. This reduces the lenders’ risk, as they make money upfront. You may need to pay higher closing costs.

Most sales mean the buyer pays other closing costs as well, including a home inspection, appraisal, title insurance, recording fees and transfer taxes. Homebuyers typically pay between 2 to 5 percent of the home’s purchase price in closing costs. The Fair Issac Corporation, which issues credit scores, offers a worksheet that helps buyers anticipate their closing costs.

These closing costs will either need to be paid upfront or rolled into the mortgage. This will impact the amount that you have available for a down payment and the size of the mortgage for which you qualify.

How much do you want to buy?

Of course, the discussion above is focused on how much you’d qualify to borrow. The larger question is, how much do you want to spend on a home?

Remember, you don’t need to borrow the maximum amount for which you qualify. Here are other factors you’ll want to consider when determining how much home you can afford:

  • Dual/single incomes. If you’re a dual-income couple, you could qualify for a mortgage based on your combined income. But do you want to obligate both of you into needing full-time careers? Or do you want to leave enough wiggle room that one spouse could later become a stay-at-home parent? If there’s a chance that both spouses may not stay in the workforce, you may want to base your buying decision on the assumption that you’ll have one income, rather than two.
  • Job security. How secure is your income, and your spouses’ income? If either of you lost your job, how quickly could you find another one?
  • Career change. Is there a chance that you’ll want to change careers, start a business, or return to school? If so, how will that impact your income?
  • Sabbaticals. Would you like to take extended time off for a sabbatical or “mini-retirement”? If so, are your housing costs reasonable enough that you could cover the payments during this time?
  • Repairs, maintenance and improvements. You’ll need to cover ongoing maintenance, like landscaping and HVAC tune-ups, as well as major repairs and improvements, like replacing drafty windows or worn-out appliances.

If you plan on buying a home, start talking to lenders and looking for properties. Median home prices nationwide are expected to rise in 2018, according to the National Association of Realtors. The 30-year fixed mortgage rate has been steadily rising since fall 2017 and may continue to grow in 2018, according to Bankrate. Together, that means you may pay more for a home, and also owe more for the mortgage, the longer you wait.

Of course, if you’re not ready to buy a home, don’t rush — home ownership isn’t undertaken lightly, and most people need to time to gather paperwork and evaluate their financial situation. We hope that you’re one step closer to your decision with the tips we’ve shared.

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