Buying a house is one of the largest investments you’ll make in a lifetime. Entering into the purchase understanding the full cost of the mortgage and homeownership itself is crucial. Keep reading to learn how to figure out how much house you can afford.
The First Step
Before you even think of looking for a home, you should know what you can afford. This requires that you take a long, hard look at your finances. You’ll need access to your latest paystubs as well as your W-2s for the last two years. You’ll also need your asset statements – the ones that show how much money you have saved for your home purchase.
Figuring Out Your Income
First, let’s look at your income. Lenders use your gross monthly income when determining how much loan you can afford. Your gross monthly income is your income BEFORE taxes. If you earn a salary, it’s easy to figure out. Let’s say you make $60,000 per year – that’s $5,000 per month. If you get paid hourly, commission, or a combination of ways, you’ll take an average of your income over the last two years based on the incomes stated on your W-2s.
How Much do you Have Saved?
Next, figure out how much money you have saved. You’ll need money for the down payment and the closing costs. Many people forget about the closing costs, but they can’t be ignored. They cost anywhere between 3% and 5% of your loan amount. On a $200,000 loan, that means an extra $6,000 to $10,000 in closing costs in addition to the down payment.
The Costs Involved in Buying a Home
As we said above, you’ll pay closing costs. They vary by lender and location, but in general, you’ll pay:
- Origination fee
- Underwriting fee
- Processing fee
- Title fees
- Appraisal fee
- Lawyer fees
- Closing fee
- Inspection fee
How Much House can you Afford?
Now that you have your figures, it’s time to figure out how much house you can afford. Lenders try to stay within a specific amount of your gross monthly income. As a general rule, lenders use 28/36 as benchmarks. This means that your monthly mortgage payment amount shouldn’t exceed 28% of your gross monthly income and your total debts (credit card payments, car payments, student loans, etc.) should not exceed 36% of your gross monthly income. Some loan programs have slightly more flexible requirements, enabling you to afford a slightly more expensive home, though.
Using the 28/36 example and a $60,000 per year salary, you’d qualify for a mortgage payment of:
$1,400 per month as long as your total monthly debts don’t exceed $400 for a total monthly debt of $1,800.
Keep in mind that the $1,400 figure includes the principal, interest, real estate taxes, homeowner’s insurance, and mortgage insurance (if applicable). Your exact loan amount will depend on the interest rates at the time as well as your credit score. You can also add any money you have saved for a down payment to that amount to find out the total cost that you can afford.
How to Calculate Your Monthly Fixed Costs
Your monthly mortgage payment amount consists of several pieces:
- Principal - This is the amount you borrow. You pay a portion of the principal back each month based on the chosen term (10, 15, 20, or 30 years).
- Interest - This is the charge you pay for borrowing the money. The interest rate determines how much interest you pay each month.
- Real Estate Taxes – This is what the county charges for you to own a home there. You’ll pay 1/12th of the annual fee each month.
- Homeowner’s Insurance Premium – This is what you pay for financial protection should something happen to your home. You’ll pay 1/12th of the premium each month.
- Mortgage insurance – If you borrow more than 80% of the home’s value or you use government financing (FHA or USDA loans), you’ll pay mortgage insurance on the lender’s behalf each month.
The True Cost of Owning a Home
The true cost of owning a home includes not only the mortgage payment, real estate taxes, and homeowner’s insurance. It also includes the cost of running a home. Think about:
- Utility costs
- Furnishing the home
- Maintenance and repairs
On average, it costs 1% of the home’s value to maintain and repair it each year, but this amount can obviously change from year to year, especially as the home gets older.
Understanding Fixed and Variable Rate Mortgages
Before you settle on a mortgage, you should know the difference between a fixed rate mortgage and adjustable rate mortgage.
- The fixed rate mortgage has a fixed interest rate for the life of the loan. Your principal and interest payment remain the same for the loan’s term. The only thing that may change is the cost of the real estate taxes or home insurance.
- The adjustable rate mortgage adjusts annually after an initial fixed period. It adjusts based on the index at the time (such as LIBOR). Lenders choose an index and add a predetermined margin to it. For example, LIBOR + 1%. That means each year your rate would be equal to the current LIBOR rate plus 1%.
Knowing how much home you can afford before you shop for a home makes it easier. You’ll know what you’ll qualify to buy and may have a better chance of getting the seller to accept your bid. Mortgage lenders can pre-approve you for a loan before you shop for a home. That preapproval letter will get your foot in the door with sellers and help sellers take your offer seriously when you make it.