How Much Can You Afford?
The trick with buying a home is getting as much as you can on your wish list without becoming house poor, which means you can afford your house payments, but you can’t afford to do much else.
That’s why lenders have conforming loan standards that they use for prequalifying you as a borrower. This is true whether you are a first-time homebuyer or a millionaire move-up buyer.
To qualify you, lenders use two ratios – income to mortgage debt, and income to total debt. Your house payment including property taxes and insurance should be no more than 29% to 31% of your annual gross income. Your debt service, added to your monthly mortgage payment, should be no higher than 41% to 43% of your annual gross income. The closer you get to 43%, the higher the risk for the lender, and you could end up paying a higher interest rate.
Before you shop for a home, you need to know what you can afford and/or what you need to change about your finances to obtain the home you want. Perhaps you should reduce debt or add more cash to the down payment you were planning to make.
FreddieMac.com offers a useful calculator that allows you to put in your personal numbers. You’ll need to know the following:
Annual gross income or preferred monthly payment
Monthly debt payments – student loan, credit cards, child support, etc.
The amount of your down payment
The term of your loan – 30 years, 15 years, etc.
The mortgage interest rate
As you input your information, you can see what you have to work with. To qualify for a conforming loan, let’s use a gross annual income of $75,000, monthly debt service of $750, a down payment of $25,000, a 30-year fixed- rate mortgage loan and a 4% interest rate. With those numbers, you can afford a home worth up to $211, 719 and a monthly payment of $1,500.
If we change a couple of numbers, so does the price of the home you can afford. Let’s reduce the amount of monthly debt to $500 and increase the down payment to $30,000. Now you can afford a home worth up to $257,549, with a monthly payment of $1,750.
Can you borrow more money possibly? Yes, you can borrow more money with an adjustable rate loan, but that’s only worth the risk in certain circumstances. If you think you’ll only be in your home a short time (less than five years), a fixed-rate loan may be more expensive than you need. You may be better off with a hybrid loan that gives you a low fixed rate for the first five years, and then adjusts to the loan market after that.
Qualifying to buy a home is only the first step. You’ll want to be able to handle whatever comes your way - repairs, rising utilities, remodeling or other updates, and ongoing maintenance.
Talk to your lender and get prequalified before you go shopping for a home. Lock in your rate, so you can calculate your payments and obligations accurately. If mortgage interest rates go up, that will impact the amount your lender will loan you.