What you can buy and what you can afford are two different things

By DONNA FUSCALDO

Updated Sep 6, 2020

When it comes to homebuying, everyone knows the critical rule: Don’t purchase more house than you can afford. But what constitutes “affordable” will differ from one buyer to the next. As of April 2020, the average price for a new home was nearly $364,500, which means that some folks pay a lot more than that, and others a lot less.1 Wherever you fall on the spectrum, it’s probable that a home will be one of the largest single purchases you’ll ever make.

Figuring out the sweet spot of affordability requires more than getting a pre-approval letter from a mortgage lender, however. First-time buyers tend to shop on the amount a lender is willing to advance them, not taking into account other expenses. This can set them up for financial hardship and even a potential foreclosure if they can’t afford the monthly payment.

KEY TAKEAWAYS

*Setting a homebuying budget involves more than seeing if you can swing a mortgage payment.

*To determine if a home is affordable, calculate your entire debt-to-income ratio: all your monthly expenses divided by your gross income.

*Homeownership involves a variety of ongoing costs, including homeowners’ insurance, property taxes, and repair/upkeep expenses.

*Affording a home means being able to make at least a 20% down payment on it; otherwise, you’ll incur costly private mortgage insurance.

The 25% Rule Can Get You Started

One of the easiest ways to calculate your homebuying budget is the 25% rule, which dictates that your mortgage shouldn’t be more than 25% of your gross income each month. The Federal Housing Administration (FHA) is a bit more generous, allowing consumers to spend as much as 31% of their gross income on a mortgage.2 But don’t forget that if you have other debts, you must consider them in addition to the mortgage payment to determine how much you can truly afford.

Mortgage lenders look at a prospective borrower’s debt-to-income ratio when determining if they will lend money.3 Let’s say your monthly mortgage payment is $1,000 a month and your other expenses are $1,000, so overall, your monthly financial obligations come to $2,000. Now let’s say you have a gross monthly income of $6,000. That puts your debt-to-income ratio at 33%.

43% is generally, the highest debt-to-income ratio a borrower can have and get a mortgage from a qualified lender.3

Homeowning Expenses Beyond the Mortgage

Getting preapproved for a home loan is an important first step in the homebuying process, but it is only one consideration. A mortgage isn’t the only recurring expense: homeownership comes with a lot of other ongoing costs, which buyers need to anticipate. These include homeowners’ insurance, utilities, repairs, and maintenance costs. Maintenance alone can add up: The lawn needs to be cut, the snow must be shoveled, and the leaves raked. Buyers also need to consider property taxes.

These expenses can add greatly to your monthly outlays, making a home that seemed affordable on paper pricey in reality. So you should include all of these costs, as well as other regular expenses, when determining how much home you can afford. A $1,500-per-month mortgage payment may be palatable, but add $1,500 in monthly expenses, and suddenly your obligations have doubled.

 Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

Down Payment Should Dictate the Purchase

Generally, lenders want homebuyers to be able to pay at least 20% of the purchase price in cash. If they can only make a down payment below that amount, they can still get a mortgage, but often must also shoulder the extra expense of private mortgage insurance (PMI).4 Paying PMI means their monthly mortgage payment will go up by anywhere from 0.5% to 1% of the loan amount.5

How much you pay in PMI will depend on the size of the home, your credit score, and the potential for the property to appreciate, among other things. If you can’t swing $60,000 down on a $300,000 home, shoot for at least 10%. The more down payment, the less interest you’ll pay over the life of the loan, and the smaller your monthly mortgage payment will be, even if you are hit with mortgage insurance.

The amount you saved for the down payment should also influence the house you buy. If you have enough to put 20% on one home but 10% on another, the cheaper home will give you more bang for your buck.

Buyers also need to set aside money for closing costs, which can amount to between 2% and 5% of the purchase price, depending on which state you live in.6 If you are purchasing a $200,000 home, you could pay between $4,000 and $10,000 in closing costs alone. The less you have to finance in the loan, the lower interest you will pay over the life of the loan, and the sooner you’ll see a return on your investment.

Choose a Property You Can Handle

When considering the affordability of a home, first-time buyers need to consider the condition and size of the property. After all, large isn’t always good, especially if heating and cooling it breaks the budget. A quaint home sitting atop a picturesque hill may be a dream come true, but shoveling that long, steep driveway during the winter months could be a costly nightmare. So could that 3,000-square-foot fixer-upper, which seems super cheap until you realize that you need to renovate every room in the house.

Look at utility bills for the properties you’re considering—and have a construction expert estimate what fixing it up could cost. If you’re planning to do it mostly yourself, be realistic about what you can handle, both in terms of skill sets and time.

The Bottom Line

Homeownership is still the American dream, but it can quickly turn into a nightmare if you miscalculate your purchase. First-time buyers, in particular, have a lot of wants, often more than they can actually handle. They must make sure that the house they purchase is affordable by considering more than just the monthly mortgage payment. Without some upfront calculations, they can find themselves house-rich but cash-poor, leading to all sorts of financial pain. Take time to cost out your dream before you sign for it.

Original Article – https://www.investopedia.com/personal-finance/how-set-budget-your-first-home/