Can You Afford to Buy a Home?
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Almost as soon as you decide to buy a house, the first question you’ll probably ask yourself is “How much house can I afford?”
It’s a crucial question — one that will go a long way toward determining the success of your homeownership experience. Aim too far down market, and in a few years you may find yourself eyeing a bigger and better property but dreading the time and expense of moving again. Aim too far upmarket, and you may soon find yourself struggling to meet your monthly mortgage payments and other expenses.
The tricky thing about the question, “How much house can I afford?” is that the answer could be very different for you and the couple in the next apartment, even if you have similar incomes. This article will explore some of the variables that go into determining how much house you can afford and how you should account for them in making decisions about home buying.
Can you afford to buy a home? Go through this checklist
LendingTree has a terrific resource called a home affordability calculator, and this article can be thought of as a companion to that tool because it will explain the importance of the inputs that go into the calculator.
The following is a checklist of the issues you’ll have to consider in deciding what numbers to plug into the home affordability calculator.
How much money do you have for a down payment?
Saving for a down payment is a significant hurdle to buying a home, and that hurdle creates a temptation to aim for the lowest down payment possible. Fortunately, there are several programs that help first-time homebuyers get into a home with little or no money down, and these will be outlined later on. However, before you automatically assume a smaller down payment is better, consider that a larger down payment has several advantages:
- Lower monthly payments. Putting more money down up front will make your monthly mortgage payments more affordable, leaving you more room to save for other priorities, such your kids’ education costs or your retirement.
- No private mortgage insurance (PMI). Lenders commonly require PMI for mortgages with down payments under 20%. PMI can add to your closing costs and monthly payments, and it can last for several years or even the entire life of your mortgage.
- A lower interest rate. Mortgage rates are determined by how risky the lender thinks the loan is. Because lenders consider loans with larger down payments less risky, a larger down payment can translate into a lower interest rate.
- Easier approval. Another benefit of having a loan lenders view as less risky is that it may make it easier to get a mortgage, even if you have a less-than-stellar credit history.
What percentage of your pretax income will you need for mortgage, taxes, and insurance?
Conventional lenders typically try to keep mortgage payments below 28% of a borrower’s pretax income. Whether this is the right number for you depends on a couple of things, including your lifestyle, other financial obligations and also the expense of the housing market in your area.
Keep in mind that for the purpose of calculating mortgage payments as a percentage of income, lenders look at not just the loan itself but other components of your monthly payment such as mortgage insurance (if applicable), homeowners insurance and property taxes.
For example, suppose you earn a pretax income of $65,000 and put 20% down on a $250,000 house. Assuming a 4% mortgage rate, $800 a year for homeowners insurance and a 1% property tax rate, this would result in you having a monthly mortgage payment of approximately $1,230, or nearly 23% of your pretax income.
Now consider what would happen if you wanted the same house but only put down half as big a down payment. With 10% down, you would be facing a monthly payment of $1,460, or roughly 27% of your pretax income. This mortgage payment would be higher in part because the lower down payment means you would have to borrow more to buy a $250,000 house, and in part because putting less than 20% down would mean you may have to make PMI payments.
While a lender may approve you in either scenario, note that making a larger down payment would leave your considerably more room in your monthly budget for other expenses and savings goals.
What is your employment situation?
Lenders are not just interested in how much money you make but also in the stability of that income. You are likely to have to provide two years’ worth of income documentation, and while it is not a hard-and-fast rule that you have to have held a job for the past two years, it certainly will make the process easier if you have.
Lenders are likely to look at your income history as more stable if you have been with one employer for the past two years rather than having changed jobs. Also, lenders look more favorably on salary income than income that can be erratic, such as commissions.
What is your current debt-to-income ratio?
As noted earlier, lenders will generally want you to keep your mortgage payments to within 28% of your income, but they are also concerned about what other financial obligations you have. To account for this, they calculate a debt-to-income (DTI) ratio that adds any ongoing debt repayments to your projected mortgage payment to see what percentage of your income will be tied up in loan payments.
Keep in mind that it is more than just principal and interest payments that go into your DTI ratio. This ratio includes other expenses associated with owning a home such as:
- Property, flood and mortgage insurance payments
- Real estate taxes
- Homeowners association or co-op fees
Your total DTI ratio also includes other monthly payment obligations, including other mortgages, other long-term or significant mortgage debts, lease payments, alimony and child support. Your DTI ratio does not include routine monthly expenses like utility payments, unless they are included in homeowners association fees.
You can qualify for a conventional mortgage with a DTI ratio of up to 50%, but a high DTI ratio is likely to require you to make a larger down payment and/or have a higher credit score.
What is your credit score?
Speaking of your credit score, this is a huge factor not only in your ability to qualify for a loan but also in determining how favorable your loan terms will be.
While you can get a government-backed FHA loan with a credit score as low as 500, you will have to put at least 10% down to have a chance at qualifying with such a low score. If your score is at least 580, you may be able to qualify with a smaller down payment. Also, FHA loans tend to be more costly than conventional loans in terms of interest rates and mortgage insurance, so you could save some money if your credit score is strong enough to qualify for a conventional loan.
Conventional loans are those eligible for financing by Fannie Mae and Freddie Mac, and since they do not have government backing they generally have tougher qualification standards. You’ll need a credit score of at least 620 to qualify for a conventional loan, and your score will have to be even higher than that if you want to qualify for a low down payment program or get the best mortgage rate possible.
Bottom line: The higher your credit score, the lower your borrowing costs are likely to be, so good credit should allow you to afford a more expensive house. You can keep tabs on your credit score right here on LendingTree.
Additional costs to consider
Lender requirements such as minimum down payments and DTI ratios are important factors in how much you can afford to pay for a house, but when deciding how much to spend you should also ask yourself whether you want to stress your budget to the max or leave room for other expenses.
You may find it wise to set your home price target a little lower in order to help you prepare for some of the additional costs associated with buying a home. Here are some examples:
Costs associated with searching for a home
Even before you make an offer on a home, you may incur costs just looking for a property. These can be relatively minor, such as the cost of driving around to different properties, but they could be much steeper if you are considering relocating. Traveling to and from a remote location plus paying for lodging while you are there can quickly get expensive, and it may take you multiple trips to find the right property.
Those search costs add to what is already one of the biggest hurdles to homebuyers, and that is saving for a down payment. Putting aside money for a down payment while you are most likely still paying rent on your current residence will be a real test of your budgeting skills. If you are planning to move to a different area, you may want to save a little extra to cover your search costs.
Application fees, appraisals and other closing costs
The cost of the actual home purchase extends beyond what you pay for the property. There is a long list of fees involved which add up to what are known as closing costs — money due from you when the purchase agreement is finalized.
Closing costs include fees for processing your loan application, home appraisal and inspection, title search, credit check, and taxes. Add in an upfront charge for PMI on some mortgages, and you are facing a significant financial hit on closing day. These costs vary widely by location, with some real estate experts saying you should expect to pay about 3% of the price of the home in closing costs, while others say you should be prepared to pay about 5%. What you actually pay could be more or less than those figures, so to best prepare yourself for the expense, research average closing costs in your area.
You can finance some of these costs, which means including them in the amount of money you borrow for your mortgage. However, if you were already planning on saving upfront money by making a low down payment, financing closing costs might push your loan-to-value ratio (the amount you are borrowing relative to the value of the property) above the limit allowed for certain loan programs.
Another strategy is to negotiate with the seller when making your offer on the home about who pays which closing costs. However, this strategy is only likely to work in a soft housing market where sellers are anxious to make a deal. All in all, the most realistic approach is to budget for these costs by saving up in advance.
Presumably, you have some furniture and other possessions that need to be moved into your new home. This is another thing you need to add to your homebuying budget. The cost of your move will vary widely depending on the number of things you’re moving, where you’re relocating, how many movers you hire and what time of year it is. To get an accurate assessment of how much money you’ll need to cover your move, many moving companies recommend you have a professional come to your home and give a quote. Price out several options to make sure you’re getting the best deal that meets your needs.
The economics are pretty simple: The more stuff you have and the farther you’re moving, the more you’ll likely spend. That can eat into the amount of money you have available for a down payment and the total purchase price you can afford.
Maintenance and repairs
Beyond all the upfront costs involved in buying a home, owning a property involves ongoing maintenance and repair costs.
The annual cost of maintenance and repairs will depend on the age and condition of your home, but common estimates run between 1-4% of the cost of the home. If you are buying a co-op or condominium some of these costs will be wrapped into homeowners association fees (which are already accounted for in your DTI ratio), but even those won’t cover everything.
Homebuyers can get themselves into trouble if they plan on putting every available penny into their monthly mortgage payments and don’t leave a cushion for maintenance and repairs. Buyers who take on too big a mortgage can find themselves caught short as soon as something breaks — and as any homeowner will tell you, sooner or later, something will.
Some of the issues discussed previously — especially the size of the down payment you can make and your credit score — will go a long way toward determining what sort of mortgage you should get. While the ideal situation is to have a good credit score and a 20% down payment so you can avoid mortgage insurance, not all would-be homebuyers can clear those hurdles. Fortunately, there are a variety of programs in place to ease the path to homeownership.
You can learn the details of these programs on LendingTree’s guide to first-time homebuyer programs, but the following is an overview of some prominent programs:
|First-time Homebuyer Programs|
|Mortgage Program||Down Payment Required||Benefits||Qualification|
|Freddie Mac Home Possible||3% to 5%||The low down payment can come from outside sources, such as gifts or even second mortgages.
Buyers with no credit score may qualify with as little as a 5% down payment.
Because this is a conventional mortgage, mortgage insurance can be canceled when your LTV ratio reaches 80%.
|Borrowers must have average or below-average incomes for their areas.
Generally a score of 660 is needed to qualify with a 3% down payment.
Must participate in a borrower education program.
|Fannie Mae Home Ready||3%||The low down payment can come outside sources, such as gifts or even second mortgages.
Because this is a conventional mortgage, mortgage insurance can be cancelled when your LTV ratio reaches 80%.
|Credit score of 680; or 700 if your DTI ratio is between 37-45%.
Limited to single-unit, owner-occupied property. Must participate in a borrower education program.
|FHA Basic Home Mortgage Loan||3.5%||People with credit scores as low as 580 can qualify for the low down payment.||Limited to 1-to-4-unit, owner-occupied properties. Subject to a property value maximum, which is $275,665 in most of the U.S.
Entails paying mortgage insurance for most or all of the duration of the loan.
|VA Home Loans||0%||No down payment or ongoing mortgage insurance requirement. Flexible credit requirements.||Veterans or active service members who meet length-of-service requirements.
Credit and DTI guidelines are flexible, but borrower must generally demonstrate ability to repay.
|USDA Single-Family Home Loans||0%||No down payment loans for low- to moderate-income buyers.||Property must be residential and located in a designated rural area.
Subject to strict property and income restrictions.
Must be a U.S. citizen or a Green Card holder.
Buying a home is a major financial commitment, but what these first-time homebuyer programs have in common is that they aim to ease the initial hurdle of raising a large down payment.
Still, in deciding, “How much house can I afford?” you have to look beyond the down payment. There are other purchase costs, and then many years of monthly mortgage payments and maintenance expenses. Before you make this long of a commitment, think about just how expensive you want that commitment to be. Also, consider whether the low down payment route is the best approach for you, or if you would be better off in the long run with the freedom from mortgage insurance and greater financial flexibility that comes with making a larger down payment.