Buying a home is no small matter. In fact, it’s one of the biggest decisions you can ever make, at least where finance is concerned. It’s important to know what you’re getting yourself into, for how long, and whether you can afford such as decision.
To be clear, becoming a homeowner is an exciting and pretty momentous occasion in your life. It’s amazing to be able to say, “this house here - this one’s mine!”
Prior to buying a home, however, you really have to do your research and figure out if this big decision will put you into a worse financial situation than initially imagined. You have to factor in every cost, huge to tiny, before signing off on such an enormous purchase.
How do you know, though, if the house you’re in love with fits within your price range? Also, how do you even know what your price range is?
Let’s talk about how to know how much you can afford when buying a home.
The Basics
There’s a time and a place to treat yourself to a financial splurge. Unless you have way over the required means, purchasing a home is one financial decision that should likely veer toward the conservative
Getting your dream home, in short, shouldn’t bankrupt you. It’s important to follow a few basic guidelines, before even getting into the nitty-gritty.
First off, try not to have your down payment go over 20% of the home’s value or purchasing price. You’ll need that money further down the road.
Secondly, there are a number of options when choosing a mortgage. A smart choice is getting a 30 year fixed mortgage, especially if the fixed rate is favorable. And since you are signing up for monthly payments for three decades, try to ensure the total of your monthly mortgage payment doesn’t exceed 30% of what cash you have flowing in.
Lastly, remember that you will be financially responsible for nearly everything in your new home. On the mortgage side of things, there will be closing costs, and if you have other debts from car payments or a credit card, remember to factor those in. Insurance for both your home and your loan are other costs to consider, and as just mentioned, if anything goes wrong, you won’t have a landlord on the line to fix things.
The Main Expenses
Aside from some basic guidelines to purchasing a home, the best guiding light you can ask for is the 28/36 rule. Let’s break this down.
The 28/36 rule is comprised of two ratios, the front end ratio and the back end ratio. The first ratio represents that all of your housing expenses (your rent or mortgage) added up shouldn’t exceed 28% of your gross monthly salary. The latter number is talking about debt, as all the debt in your household shouldn’t be more than 36% of that same salary.
Regarding expenses, there are four important monthly costs you should put at the forefront of your thinking on home affordability. These are called PITI, or Principal, Interest, Taxes, and Insurance. Your underwriter, lender, and other folks working with you will mention PITI a lot.
The highest of your PITI costs will be the Principal, which is the money you owe month to month to pay down the cost of your home. However, it’s not the only cost, albeit the one you likely focus on the most - it’s important to remember that PITI represents that all costs matter and add up.
Making up PITI is also Interest, which is what the creditors will be charging you month to month for giving you the Principal in the first place. Then there’s Taxes, or property taxes on your home, and Insurance, comprised of your homeowner’s insurance and other lender insurance.
All these factors come together to form your front end ratio. To get the ratio itself, all you have to do is divide the total PITI by your gross monthly income, then multiply by 100. As long as it’s 28% or under, you are in a good spot.
Debt Income Ratio
Your expenses are only part of the story. When approaching the decision to buy a home, one of the most important things you have to think about is all your debt. This means anything that may be affecting your credit score - remember that lenders are going to scrutinize your credit score like nothing else.
As mentioned before, debt in this case is calculated for the household. So if you’re purchasing a home with a partner, lenders will look at the debt of everyone signing off on the home purchase. They will also take a gander at all credit scores involved.
After you put your money down and you dig your heels in for the long haul of paying off a mortgage, don’t forget that you will be adding that to credit card payments, possible student loans, car payments, and so on. You really want the monthly amount your paying on money owed to be low, as having low debt will make you a better candidate for good interest rates, and you’ll simply have less to pay down while adding home payments on top of everything.
To get your back end ratio, or debt to income ratio, total up all your monthly debt and divide that by your gross monthly income. Multiply this by 100 and hope it’s 36% or lower, as a higher debt to income ratio may be discouraging factor in affording a home.
If you follow the 28/36 rule closely, and keep track of all those huge and tiny costs associated with home-buying, you will likely be just fine and make it to closing without too many financial bruises. Buying a home is costly and intimidating, so know it’s going to be a challenge, but the rules and guidelines are there to help. Remember too that you can ask your lenders about this too - knowing these terms and guidelines may not give you 100% of the information required, though it’ll help when asking the right questions.
