How much house can I afford?
Key factors to consider in understanding how much house you can afford includes; your monthly income, available funds to cover your down payment and closing costs, your monthly expenses, and your credit profile.
Income – Money that you receive on a regular basis, such as your salary or income from investments. Your income helps establish a baseline for what you can afford to pay every month.
Funds available – This is the amount of cash you have available to put down and to cover closing costs. You can use your savings, investments or other sources.
Debt and expenses – It's important to take into consideration other monthly obligations you may have, such as credit cards, car payments, student loans, groceries, utilities, insurance, etc.
Credit profile – Your credit score and the amount of debt you owe influence a lender’s view of you as a borrower. Those factors will help determine how much money you can borrow and what interest rate you’ll be charged.
We discussed previously how to obtain, interpret, and improve your credit score. The credit score needed to obtain a mortgage varies by the lender but generally, it should be in the “good” range or 680 or higher for conventional loans. FHA mortgages require a minimum credit score of 580.
The next vital factor is your debt to income (DTI) ratio. Your DTI ratio is calculated by adding up all of your monthly debt payments and dividing them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out. For example, if you pay $1500 a month for your mortgage and another $100 a month for an auto loan and $400 a month for the rest of your debts, your monthly debt payments are $2000. ($1500 + $100 + $400 = $2,000.) If your gross monthly income is $6000, then your debt-to-income ratio is 33 percent ($2000 is 33% of $6000). Depending on your individual qualifications, lender requirements, and your geographic location your DTI ratio should be between 36% and 43%.
Don’t underestimate the importance of the down payment. A larger down payment will enable you to lower your loan amount, lower your monthly payment, improve your chances of getting your offer accepted in a competitive market, and avoid private mortgage insurance (PMI). The lower you total loan amount equates to a lower monthly payment assuming all other factors remain the same. The housing market has been very competitive so having a sizable down payment can be a significant advantage if there are multiple offers on a property. Sellers often evaluate the quality of the offer in addition to the amount of the offer. An offer from someone that is pre-approved and has a sizable downpayment often makes the difference between having your offer accepted or not. PMI is for the benefit of the lender and is imposed when a down payment of less than 20% is paid. The amount of PMI varies based on loan to value ratio which is the amount of the mortgage compared to the value of the house. PMI generally ranges from $30 - $70 per $100,000 borrowed.
It is very important to understand that just because somebody will lend you a large amount of money it does not mean you should borrow that amount. This was certainly evident in the housing crisis a few years ago. I know of several people who regret their decision to take on a large mortgage which has negatively impacted their lives for years. Remember that mortgages last 15, 20, or 30 years, therefore, it is important that you and your spouse are comfortable with the loan amount and the terms of the loan.
You may want to think twice about the following mortgages:
- 40 year fixed rate.
Yes, fixed rate mortgages do provide interest rate certainty but you are still paying interest. The longer the term of your loan the more you interest you pay. Example:
$250,000 30 year loan @ 4% = $176,965 in interest.
$250,000 40 year loan @ 4% = $247,047 in interest ($70,082 more)
- Adjustable Rate Mortgages (ARM)
ARMs are attractive because they may offer a lower interest rate. However, the “adjustable” part of the mortgage can come back to bite. An increase of a couple of percentage points can make your once attractive mortgage unaffordable.
- Interest Only Mortgages
These mortgages may be attractive because your monthly payment is low because you are only paying the interest for the first few years of the life of the loan. These payments are not applied to the principle of the loan which means you will have to make higher payments to pay off the loan on time.
- Interest Only Adjustable Rate Mortgages
Combining two attractive ideas does not always make for a financially wise idea.
It is also advisable to shop around for your mortgage. You bank and credit union where you normally conduct your banking may or may not be able to offer the best terms. Mortgage brokers may be a good alternative as they have access to multiple lenders. Locking in your interest rate is often a wise choice since rates can change from day to day. This is especially true during a volatile time where rates may increase quickly and significantly. If you do nothing else please read your loan documents. It is critical that you understand what you are agreeing to and reading the loan documents is the only way to make certain you do. Having someone knowledgeable explain the terms is often helpful but nothing replaces reading the terms for yourself. Don’t be embarrassed to ask questions and ensure your lender answers all of your questions before signing on the dotted line.
Purchasing your new home can be one of the best experiences if you are prepared. Take the time to review your credit, shop around for the best mortgage and celebrate when you get the keys to your new home.