House hunting is so much fun! You walk through a variety of dream homes envisioning your life within its walls. Then you fall in love with a certain house and make an offer. Everything is falling into place until your mortgage company breaks the news: you don’t qualify for the loan. Your dreams are dashed with one rejection. That specific house is out of your league.
How can you avoid this kind of disappointment? Find out how much house you can afford before you set foot in the relator’s office (or any open houses for that matter). The worst thing you can do when buying a home is looking at properties that you cannot afford.
Wants vs. Needs
There is a lot to consider when buying a house. Figuring out what you need vs. want and what you can comfortably afford is top of the list. Too many buyers have fallen victim to mortgage brokers and sales agents how convince them that they “qualify” for more house than they need – or can realistically afford.
The best way to avoid finding yourself stuck with a mortgage you can’t handle is to be prepared. To get prepared, learn what the mortgage process is all about, and don’t get your heart set on a house before you know what you can really afford.
Take a Realistic Look at the Cost of Home Ownership
Houses are expensive. The mortgage is only one expense in a long list of new expenses you will be faced with juggling. Few first time home buyers fully understand the financial commitment of owning their own home.
First, there is the mortgage, and then there is the insurance and the taxes. Add to that higher utility bills (houses are bigger than apartments), maintenance costs and remodeling. Things break all of the time – even in brand new homes. Those repairs cost money. Plus, there is the novelty of putting your stamp onto your home. Even cheap aesthetic changes like paint and furniture can begin to stress an already tight budget. Maybe you don’t plan on hiring a landscaper, but you are still going to need a mower and other tools if you plan on doing your own yard work. And that’s only the beginning!
Before you ever head to the realty office or mortgage broker, make a list of all of the expenses you currently have, plus the new ones you will incur once you buy a home. Most financial experts agree that your total debt (including all loans, credit cards bills and your mortgage), should not exceed 30% of your net income. While a mortgage company may allow you to borrow more (their ratios are often 36% of your gross income), allowing your debt ratio to grow beyond 30% of your net income often does not leave enough buffer to handle emergencies or lifestyle changes (like a new job; layoff; medical emergency; or family addition). Life will throw you some curve balls along the way, so be sure you are prepared to handle them.
Once you have determined how much your debt costs you per month; and calculate the 30% amount from your income, you will know exactly how much money you can spend each month on a mortgage.
But wait! There is more to consider. Think about your other expenses that are not considered “debt.” This includes things like going out, vacations, internet service, new clothes, etc. All of these costs can really add up. You may think you can give up buying new clothes right now, remember, buying a home is a permanent decision. While you may be able to tighten you belt for a while, you won’t be able to give up the niceties of life forever.
This is the stage of budgeting where you need to be very honest with yourself. If you cannot imagine not going out to eat at least once a week, be sure to include that in your expenses. Otherwise you may find yourself short on cash (and very unhappy) in the months to come.
Once you decide how much you can realistically afford in a mortgage payment, it is time to make an appointment with a lender to obtain a pre-approval. This will require you to fill out an application and go through the entire mortgage process before you have chosen a house. Why go to all of that trouble? The biggest benefit of obtaining a preapproval for a mortgage is that it will give you bargaining power with potential sellers. Since your financing is set, you can act more quickly and agree to a faster closing date, and that may be the only nudge the seller needs to choose your offer over another.
The amount of money a mortgage lender is willing to give you will depend on several factors:
• Your income
• Your current expenses
• Your estimated home expenses
• Your credit score
If you have already run your own numbers and have determined a loan amount lower than the bank’s projections, you will likely be approved without much hassle.
The Benefits of a 20% Down Payment
Many new homebuyers make the mistake of trying to buy 100% of the housing cost (and sometimes even their closing fees too). This can be a big mistake for many reasons:
1 You will need a excellent credit score to qualify for this type of loan
2 You will be forced to pay PMI (mortgage insurance), which will increase your monthly payment
3 If you need to sell your home within the first 10 years, you will likely lose money on the transaction
4 You will pay a higher interest rate – which will cost you more in the long run
By saving at least 20% of the purchase price of the home you will have instant equity, plus your overall monthly costs will be lower. PMI is a type of insurance that mortgage companies require borrower’s to pay until they have 20% equity in their homes. Costing 1% of the overall price, this can be hefty sum each month. Plus, the more equity you have in your home (thanks to the down payment), the lower interest rate you will have. Dropping juts 1% on a %150,000 loans can save you $200-$300 each month. That may not sound like a lot until you consider the savings over a 30 year loan!
When calculating how much house you can purchase, you can factor in the down payment one of two ways:
• If you qualify for a $200,000 mortgage and have $40,000 saved you will only have to borrow $160,000.
• Or if you qualify for a $200,000 mortgage and have 20% saved for a down payment, you can purchase a $250,000 house.
Either strategy works. It really depends on how much you want to borrow and what kind of house you really want.
Choosing Your Dream Home
When deciding how much house you can afford right now, consider all of the costs associated with buying a new home, and then factor in extra for emergencies; life changes; and fun too. While buying a home is exciting, don’t allow yourself to get carried away. Your financial future depends on making a smart choice right now. If you really believe that you can afford a $200,000 house, look at houses in the $150,000 range and see if there is anything you like. If not, you have room to expand your search. But, if you jump right into looking at $200,000 properties, you may be tempted to stretch yourself for “just a little more.” And that can turn into a catastrophe down the line.
Staying within a budget doesn’t have to mean giving up your dream house. It only means that you may have to tweak your expectations a bit. However, the payoff will be the peace of mind in knowing you can handle those monthly bills – no matter what other unexpected expenses come your way in the future.