Are you thinking about buying a house? Homeownership can be an exciting time, but it can also bring up a lot of important questions: How big of a loan can I afford? Will I qualify for a mortgage? How much money will the lender require me to provide up-front?
Here’s what you need to know about how much you should spend on a house.
What Can You Afford Every Month?
The first question you should be asking yourself is how much you believe you can afford to spend on a house every month? This is a serious point to consider because once you lock into a 30-year mortgage, you’re going to be committed to making this payment for a very long time.
If you’re already spending money on rent or another house, how stressed are you by the payment? For example, if your costs are $1,000 per month already, how easy or difficult is it for you to come up with this money for housing every month?
Sit down and have an honest review of your finances. Go through your bank accounts and credit cards, and consider how much of your budget is truly leftover after you pay your debts, food, car payments, insurance, and any other expenses you already have. You could also use an app like Mint or YNAB to help categorize your spending and look for trends.
How Much Down Payment Will You Have?
In addition to how much mortgage you can afford, another important question to ask yourself is how much money you’ll be able to bring to the table up-front as a down payment.
The classic, ideal down payment amount is a minimum of 20 percent. For example, if you plan to buy a house that costs $200,000, then typically you should bring $40,000 with you for the down payment.
However, over the past few decades, lenders have become more relaxed about the down payment and will often accept less. According to the National Association of Realtors, most U.S. homebuyers put down just 12 percent when they go to buy a house. As a matter of fact, most conventional loans will even allow as little as 3 percent for a down payment. Even the government’s FHA (Federal Housing Administration) loan only requires 3.5 percent.
However, tread carefully on these numbers. There are a few things that happen when you bring less than 20 percent for a down payment:
- You will be required to pay something called PMI (private mortgage insurance), which protects the lender in case you default on the mortgage. PMI varies in price but can easily add another $100 or so to your mortgage every month.
- The less you put up-front on the down payment means the bigger your loan will be. Therefore, you’ll have bigger payments and more interest to pay over the life of the loan.
- Closing costs will also be higher. Generally origination fees are one percent of the total loan.
So even though a low down payment may seem like a good idea, use caution. Try some numbers for yourself using a simple mortgage calculator like this one from BankRate.
Raiding The Retirement Piggy Bank
We all know investing in retirement is important, and although pulling money out of your retirement funds early isn’t really the best choice, it may interest you to know that it is an option. The IRS will allow first-time homebuyers to withdraw as much as $10,000 from their IRA to use towards their down payment. Couples who both qualify can take out as much as $20,000. Unlike most early withdrawals, this one is penalty-free. However, you will still owe taxes on it when you go to file your return.
How Much Can You Borrow?
Figuring out your budget is only half of the battle. Next, its time for the banks to say how much money “they” think you should spend on a house.
Generally, this will be determined by two ratios:
Rule Of 28 – Maximum Mortgage Payment
This formula (also called the front-end ratio) says that your monthly mortgage payment should not exceed 28 percent of your gross monthly income. This figure should include not just your principal and interest payment, but also any money you’d also hold in escrow for other expenses such as property taxes, homeowners insurance, and PMI.
For example, if you earn $50,000 per year before taxes, then according to the bank, your total monthly mortgage payment should not exceed $1,400 per month.
Rule Of 36 – Maximum Debt
This formula (also called the back-end ratio) says that your total debt payments should not exceed 36 percent of your gross monthly income. This figure includes your (assumed) housing payment, credit cards, auto loans, student loans, and even child support.
For example, if you earn $50,000 per year before taxes, then according to the bank, your overall debt should not exceed $1,800 per month.
How Strict Is The 28/36 Rule?
So if you don’t meet the 28/36 rules, will you automatically be disqualified from getting a mortgage?
In short, no. These are guidelines that most conventional lenders will use to access your creditworthiness, but they are not hard and fast rules.
In reality, lots of lenders will be willing to make exceptions if you’ve got a great credit score, large down payment, manageable forms of debt. Also, buying a home with an FHA mortgage can bump you up to a 31/43 rule.
Other Important Considerations When Buying A House
There are a few other important points you’ll want to consider as you’re trying to determine how much house you can afford:
Like it or not, your credit score will impact your ability to qualify for the loan. But that’s not the only advantage. A high score will also help you qualify for the best possible interest rate. This is why its always in your best interest to check your credit report regularly and make sure your score is as high as you can make it.
Location And Taxes
Not all land is taxed the same, and it’s important to remember this as you’re shopping around for a house. For example, you might find the taxes near the city are significantly higher when compared to another house that’s only 10 miles away but outside the city limits. Obviously, a lower tax bill will mean a lower overall mortgage payment.
Maybe the house you’d like to buy is in your price range but is going to require an additional $20,000 in renovations to bring it up to date. Alongside your down payment, this yet another up-front cost you’re going to want to take into consideration when looking at the big picture.
Mortgages aren’t free. Between the underwriting, appraisal, inspections, and various fees, the closing costs can add as much as 2 to 5 percent on top of your loan. Take this into consideration when you’re estimating how much money you need to bring to the table at closing.
Alternatively, most lenders will try to make things simple by rolling the closing costs into the loan itself. However, that means a higher monthly payment and interest for the next 30 years on these expenses.
Finally, is your new house in a neighborhood that charges a monthly homeowner’s association (HOA) fee? You might be required by their bylaws to pay another $100 per month or so for the maintenance of the neighborhood, roads, landscaping, etc. Be sure to ask the realtor since this is yet another expense that you’ll want to take into consideration.