If you’re a first-time home buyer, fully wrapping your head around becoming a homeowner (and all that comes with it) could feel a little overwhelming. It’s a big life event and you should be excited! Driving your favorite neighborhoods or scrolling through pictures of your favorite virtual listings can help you narrow down what you may want, but there’s a lot more that should go into your decision making, too.
Without knowing how much house you can afford, your search can become a more stressful and meandering process than it needs to be. With that in mind, and to help you avoid stress when buying a home, here are some factors to consider helping you determine how much home you can afford as you begin the process.
Your Income
The amount of money you bring in plays a significant role in wise home purchasing decisions. If you’re paid an annual salary, the calculation is relatively easy. Your salary may include potential additions such as overtime, bonuses, and commission – pay that is not as guaranteed as your bi-weekly or monthly income is best left out of equations in this case. Salaried or not, consider your realistic net monthly income – your take home after taxes and payments towards health benefits are withdrawn. Generally, the higher your monthly net income, the higher the price of the house you can afford to pay for in a monthly mortgage.
It is recommended that your monthly house payment (which is determined by your mortgage loan, covered below) is less than a quarter of your net monthly income. For instance, if your monthly income is $5,000, you’ll typically be advised to ensure that your monthly house payment is $1,250 or lower. It is important to remember that outside of mortgage payments, there are additional monthly or annual costs associated with owning a home, like property taxes, homeowner’s insurance, and more.
Homeownership Costs
Prospective homeowners often underestimate the actual cost of purchasing and maintaining a home. Your mortgage payment is the main, but not the only portion of the overall cost of homeownership. There are a number of additional expenses which will greatly protect your investment in the home, but often need to be addressed monthly and considered in your budgeting. Some of the monthly median costs you’ll want to have on your radar include the mortgage payment, monthly property tax, utilities, home insurance, HOA dues, landscaping upkeep, and repairs.
Of all homeownership costs, repair expenses are the hardest to forecast. This being the case, most people are not usually prepared for the big repairs such as an A/C or heating unit, a major plumbing issue, or damage to the roof — and even costs for more common repairs like a wonky faucet, a broken floor tile, or a faulty power outlet can add up and catch you and your budget off guard. A good rule of thumb is to set aside at least 1% of your home’s buying price to use for repairs. This means if you bought your home for $300,000, you should save $3,000 per year, or $250 each month to use on home maintenance.
Credit History
When it comes to determining your mortgage rate, your credit score is a key determinant. Credit score is a measure of your financial health and provides insight to lenders about your bill paying habits. Generally, the higher your credit score is, the better your mortgage terms will be.
Generally, a 620 or higher score is required to qualify for the most common mortgage products. If you’re not quite there, there could still be options for you to secure a home loan – more about mortgage options below.
Your Budget
Setting a home buying budget involves more than determining if you can afford a mortgage payment. If your current housing budget is comfortable and abides by the applicable items mentioned previously, then it is likely the right amount you should consider for a mortgage payment target.
In addition to having a complete handle on your monthly income, you must also factor in obligatory monthly expenses and consider an ‘adjusted net income.’ Using this, you can determine how much is going toward living costs or savings for various purposes – and you can then back into a conservative homeownership budget.
When determining your real money usage, it may at first seem easy to say that you can change your spending trends to save money in preparation for homeownership. Cutting out unnecessary expenditures is often recommended but be realistic in your current spending assessments. Buying a home is a big life change, layering that with a lifestyle change from cutting out certain spending habits cold turkey could backfire. If it’s your goal to live on a smaller percentage of your income, know that learning to do so is a habit, a skill, and a discipline. It can help people reach their financial goals, but as with any habit breaking and making, it can come with its own stresses and even failures. Money that ‘could be saved’ should not be factored into your budgeting for future homeownership.
Your Down Payment
Saving for a down payment is the first major step toward buying a home. The convention for decades has been to pay a 20% down payment. But there are more options now for down payments – especially for first-time home buyers – depending on your chosen mortgage type, lender, and sometimes even the homebuilder. Some options accept down payments as low as 3.5%, as in FHA loans, or you could pay zero down with a Rural USDA Home Loan, and there are special options for military veterans, as well. Be sure to consider all the details whether choosing a conventional home loan or something else, as there may be certain requirements, qualifications, and stipulations involved.
In the end, the price you agree to pay for the home is the price of the home. The amount to be paid monthly over X number of months is only changed by the amount you decide to pay upfront, before those monthly costs are calculated. In general, the higher the down payment, the lower the monthly payments and the lower the down payment, the higher the monthly payments.
Remember, not all lenders offer these types of programs and loan types, so you’ll want to investigate a few before committing to one. As part of the due diligence process in choosing a lender, it’s wise to talk with lenders about your situation, goals, and expectations. With expert and tailored advice, you can get a good idea of what to expect financially in buying a home, and how much to pay in your down payment.
Closing Costs
You’ll also need cash for immediate closing costs. These are fees associated with the home that buyers and sellers typically incur to complete a real estate transaction. The funds can’t typically be borrowed because that would raise your loan’s percentage ratio – in other words, these fees are mandatory and the norm in every home purchase.
Closing costs typically range from 2% to 5% of the home’s purchase price and may include title insurance, attorney fees, appraisals, taxes, and more. For instance, if your home costs $200,000, you could pay between $4,000 and $10,000 in closing costs. Note that in cases where you are buying a new build, the homebuilder may have a certain relationship with a mortgage lender and there could be certain incentives that would lower closing costs.
Types of Mortgage Loans and Options
There is a wide variety of mortgage products to choose from. Mortgage types have different features to meet different needs for people in different circumstances. It is always advised that you shop around to find the mortgage that’s right for you and that will allow you to meet your goals and obligations. Many online tools can help you do this – you can even usually schedule free, no obligation consultations with many lenders.
Fixed-Rate Mortgage: The most popular loan is the fixed-rate mortgage, which offers terms of 10, 15, 20, and 30 years. Your monthly mortgage payment will remain fixed over the length of your mortgage. That means your mortgage payment will be predictable and steady. This offers you a consistency that can help make it easier for you to set a budget.
VA Loan: The VA loan is a $0 down mortgage option available to eligible veterans and service members. These loans are backed or guaranteed by the Department of Veterans Affairs. The property location determines maximum loan amounts. This type of loan is an attractive option because it doesn’t require a down payment.
An Interest-only Mortgage: An interest-only mortgage is a type of mortgage that never reduces the principal balance. While interest-only mortgages mean lower payments for a while, they also mean you don’t have to repay the loan until the agreed period expires.
Adjustable-Rate Mortgages (ARM): An adjustable-rate mortgage is a mortgage with an interest rate that is adjustable. Each lender decides how many points it will add to the index rate. A standard ARM usually begins with a lower interest rate than a fixed-rate loan. After the period’s passed, the interest rate resets yearly or monthly.
While it is true that your upcoming home purchase is likely going to be the largest transaction and investment you’ve ever made up to this point, try not to be discouraged by the technical terminology and newness of the process. In the end, buying a home is just a very large purchase and determining how much home you can afford simply requires knowing your income and demonstrating prudent monthly and yearly budgeting. The above-mentioned items are meant to provide you with some thought starters as you begin to consider buying a house and seeking professional advice for the best ways for you to move into homeownership.
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