This is one of the biggest questions people face when considering purchasing a home. Lenders frequently approve a home loan far above what people are realistically able to purchase. This can leave you house poor and really strapped for cash. This is mostly due to the fact that lender approvals and limits are based upon your gross income and do not account for income tax with holdings, health insurance and retirement savings – all things that come out of your paycheck before it hits your bank account.
What do you need to consider? In order to maintain a healthy budget, your mortgage, property taxes and home owners insurance should account for no more than 25%-30% of your take-home pay. These numbers will vary depending on a few key pieces of information.
- Interest Rate – Your FICO credit score will greatly affect the interest rate quoted by your lender. A rate difference of even a ½% can have a significant impact to your monthly payment. Additionally, you will want to look at the APR. This is the effective rate of your loan. It will be higher than the interest rate as it rolls in additional fees from your lender to give you a more accurate picture of interest you are paying on the loan. If this number is significantly higher than the interest rate, there are some hefty fees included in your loan.
- Loan Terms – What kind of loan are you getting? Is this an FHA loan, VA loan, conventional loan? There can be addition monthly fees associated depending on your loan. Is this a 30-year, 15-year or ARM (adjustable rate mortgage)? I would highly suggest avoiding loans with ARMs. It may make your payments lower initially, but the rate will continue to adjust throughout the life of the loan which can drastically affect your monthly payment and therefore ability to pay.
- Down payment? How much are you putting down on the home? If you have less than 20% to put down on the home, you will be required to pay PMI (private mortgage insurance) or MIP (mortgage insurance premium). Depending on the size of your down payment, this number can be anywhere from 0.5% to 1.5% of the loan value. To determine this number, multiply the loan balance by the percentage and divide by 12. This tells you how much extra per month you will pay on top of your principal, regular interest, property taxes and home owners insurance. For example, let’s say your PMI is .78% and your loan is $200,000.
$200,000*.0078 = $1,560/12 = $130 additional per month
- Regular Maintenance – what is the condition of the home? Even new home construction will have maintenance requirements. It is estimated that a typical home will require approximately 0.5%-1% of the home value in maintenance and repairs each year.
- Do you have an emergency fund? You need to have 3-6 months of emergency living expenses in a savings account prior to purchasing a home. The very last thing you want is for your dream home to become a living nightmare because you cannot afford to fix and maintain the home without putting yourself further in debt.
While this is not a completely exhaustive list, it will give you a good idea of what you can reasonably afford in purchasing a home. The best decisions come with information, thought and time.