To understand how much home you can afford, you need to consider two important factors – what the lenders approve you for and what fits your budget. The good news is that these budget guidelines tend to be aligned. Even so, you need to make sure that you are not taking over more house than you can afford just because the lender is willing to approve a loan for that amount.
How Much Home Can I Afford?
Lenders look at a long list of criteria to determine the number of homes they want to approve you for. The list includes things like your current monthly debt payments, your total debt, your income, your creditworthiness, your current assets, how much down payment you can make, and the current state of the economy.
1. The 5 Cs of Lending
According to Wells Fargo, lender approval can be summarized as the five Cs – credit history, capacity, collateral, principal, and terms.
Credit history is your credit history, and your past credit history can be found on your credit report. Capacity refers to what you can afford. Often times, this is a look at your debt-to-income ratio – how much you pay in debt each month and how much income you are bringing in.
Home purchase collateral is the physical home that you are buying. This collateral will be confiscated by the bank or lender if you fail to repay your loan. Capital is about the other assets you may need to pay back the loan, and the terms are the purpose of the loan, the market environment, and the status of the economy.
[Related: How Does Credit Score Affect Mortgage Rates?]
2. The rule of 20
One rule that may be a little out of date – but is still cited as important – is rule 20. Under this rule, homebuyers shouldn’t buy a home unless they are willing to pay a 20% deposit on top of the additional costs. to afford connected with the purchase of the house. For example, if you want to buy a home for $ 300,000, you should be prepared to pay a $ 60,000 down payment under this rule.
However, this rule is seldom the case these days. According to the 2019 National Realtors Association report, 86% of homebuyers funded their home purchase and the average down payment was 12%. For first-time home buyers, 94% funded the purchase and the average down payment was 6%.
The reality is that when you are able to drop 20% on a home purchase you will often get a better interest rate and be in a much stronger financial position. Is It Totally Necessary? 86% of home buyers don’t believe this. You need to assess your unique financial situation to determine whether the rule is fully applicable.
3. How Much Mortgage Can I Afford ?: The 28/36 rule
Using rule 28/36, potential home buyers compare their gross income to their expected home payment and other debt responsibilities. According to this rule, no one should buy a house whose housing costs would be more than 28% of their gross monthly income. As a reminder, gross income is the amount you earn before taxes.
Note: Typically, housing costs are mentioned, not just your mortgage payment. This would include things like property taxes, homeowner insurance, homeowners association fees, and community development fees. It doesn’t include things like utilities.
For example, if you are bringing home a pre-tax income of $ 5,000 per month, the total of your mortgage payments and other housing expenses described above should not exceed $ 1,400.
The second half of this rule deals with all of your debt responsibilities that you owe for the month, including the cost of buying a new one. The total amount of these monthly payments should not exceed 36% of your gross monthly income. This should include expenses such as credit card bills, student loan payments, car payments, and any other form of regular debt payment that you are required to make.
[Read: How To Budget For a Home: An Interactive Workbook For Teens]
Can i afford a house?
A popular way of answering the question, “Can I afford a house?” consider it a percentage of your income. This method is pretty similar to the first half of the 28/36 rule, but does not involve any additional housing costs.
1. Add up your total monthly income
Add up all of your various monthly sources of income. This includes your paycheck, your significant other’s paycheck (if you have one and it contributes to your household), and any sideline business that you earn on a regular basis. Calculate this number without any taxes or other deductions from your check.
2. Multiply that number by 25%
When you have calculated your gross monthly income, multiply that number by 25% or 0.25.
3. Use this as a guide when shopping for homes
The number you get from this calculation should be the maximum you can spend on your monthly mortgage payment. However, it is important to note that this does not mean that you have to spend the amount. It is perfectly acceptable to spend below this amount.
[Read: 17 Things to Know Before Buying Your First Home]
The Hidden Costs of Buying a Home
It’s easy to overlook many elements of the buying process and think that the only cost of buying a home is your mortgage payment. These hidden costs need to be factored into your budget as well. Otherwise, you might run out of money in a situation where you thought you were okay.
These hidden costs include, for example, Homeowner’s Association (HOA) fees, community development fees levied by the neighborhood, homeowner insurance premiums, moving costs, closing costs, landscaping costs, and property taxes.
Tips for a more expensive house
The rules that have been put in place to determine how much mortgage you can afford have some leeway. If you are able to make a few small adjustments to the process, you can potentially afford a more expensive home.
1. Save for a larger deposit
Your mortgage payment is based on the size of your loan, not the value of your home. By saving for a larger down payment, you can decrease the size of your loan, thereby lowering your monthly payments, total interest, and total financial obligation. This can mean waiting a little longer to buy a home, but it can allow you to afford a more expensive home if that is your goal.
2. Increase your credit score
One of the five Cs of lending is credit history. Lenders are more likely to lend large amounts of credit to a borrower with a proven history of good credit history. As you work on improving your credit score, you may be able to get a lower interest rate, which in turn increases what you can afford to spend on a home.
3. Select a larger search area
If you are trying to afford a more expensive home, you are likely to be more concerned about getting more home than just buying a home at a higher price. When you’re ready to expand your search scope and criteria outside of your original search, you can unlock the ability to get more bang for your buck. This depends a lot on the region you are in and the deal breakers – things like schools, prime residential areas, and proximity to work or leisure.
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