Understanding Mortgages

How much home can you afford?

“How much home can I afford?” is the first question many buyers ask so you are certainly not alone. If you want to figure out whether or not you can buy the home of your dreams, read on.

Consider Financial Priorities

Buying your home probably isn’t your only financial goal. You may also want to:

  • Fund your retirement
  • Send a child or two to college
  • Take vacations
  • Buy a car

In other words, depleting your life savings and forcing yourself to live paycheck to paycheck may not be the wisest course of action when considering how much you want to spend on a home.

Keys to your success

Clean Up Your Credit

One of the first things you can do to make your home buying dollar go as far as possible is to clean up your credit. The better your credit, the lower the interest rate you’ll qualify for, and the more money you’ll be able to borrow. If you have credit concerns, contact your mortgage consultant. They may be able to give you some pointers or refer you to a financial planner.

Pre-approval

One means a lender will use to determine how much home you can afford is to measure your total monthly housing costs. To determine your cost ratio, take the Principle, Interest, Taxes and Insurance (PITI) and divide by your total monthly pretax income. Most lenders like to see a maximum of 29% of your income go towards housing, but some will go higher.

The other ratio lenders consider to be crucial to your ability to afford a home is your total debt ratio. To calculate your total debt ratio, add your PITI plus your payment for any other loans (car payment, credit cards, etc) and divide by your total monthly pretax income.

For ratio calculation purposes, credit card debt uses the minimum monthly payment. Also if you have installment debt (such as a car payment) with less than 10 months remaining, you can generally ignore that debt when figuring this ratio. Most lenders would like to see no more than 45% of your total income go to mortgage payments and other debt.

It’s an excellent idea to be pre-approved for a mortgage before you start seriously looking at new homes. It’s an unpleasant shock to have your heart set on the home of your dreams only to find out you can’t qualify for a mortgage in that price range.

Home-buying Assistance

The federal government offers assistance through programs such as Freddie Mac, Fannie Mae, VA and FHA. Benefits of these programs may include smaller down payments, higher maximum debt to income ratios and lower mortgage insurance costs.

If you have not owned a home in the past two years, you can use a portion of your IRA funds towards your down payment. You could also consider borrowing from your IRA. Consult an accountant for the exact details.

Receiving a gift of money to use as your down payment is also a possibility. Tax laws allow gifts of several thousand dollars a year without tax consequences to either the giver or recipient. The gift exclusion amount is periodically adjusted to reflect inflation so check with an accountant or the IRS for the current year amounts.

Understanding Costs

Many potential home buyers don’t realize what is included in the actual cost of buying a home. Just because a home is listed at $250,000 doesn’t mean that’s all you’ll need to pay. You may also need to factor in:

  • Down Payment
  • Closing Costs (typically 2-5% of the sales price)
  • Loan Origination Fees
  • Private Mortgage Insurance (if needed)
  • Property Taxes and Hazard Insurance
  • Moving Expenses
  • Inspection Costs
  • Attorney’s Fees

PMI

Private mortgage insurance is required for any mortgage that is financed for over 80% of the value of the house. PMI runs about 1% of the cost of the home, so it does add a substantial amount to your monthly payment. There are some ways around paying PMI—talk to your mortgage consultant about your options.

Other Considerations

When determining how much home you can afford, you may want to think about any renovations you plan for the house, decorating and maintenance. Although these items are not figured into the ratios for qualifications purposes, they are expenses you’ll incur nonetheless, so it makes sense to include them for your own planning.

The safest bet, when determining how much home you can afford, is to ask your mortgage consultant. They can help with all the needed figures as well as a no-obligation pre-approval, you only have to call.

Before you buy your home, consider living for a few months as if you were already paying the new mortgage amount. Not only will it answer your question (can I afford this home?), but you’ll have a little extra socked away in savings.