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By Catherine Alford
Updated: June 16, 2020 3:06 PM ET | Originally published: February 14, 2020
Money; Getty Images

Being able to buy a house remains a big part of the American dream. For many of us, it can signal we’ve arrived into adulthood or achieved a significant life goal. But despite how thrilling the prospect of homeownership may be, the actual process of financially preparing to buy a home can be seriously daunting.

If you’re in the market to buy a home, you might be wondering, “How much house can I afford?” Perhaps you have a general idea of how much you’d like to spend, but the excitement and emotions of house hunting can make you forget about the math.

To that end, it’s also important to have a good understanding of the home buying process before you set out on the journey, particularly if you’re a first-time homebuyer.

Throughout the home buying process, prepare to meet and work with professionals such as:

  • Real Estate Agents (Buyers and Sellers)
  • Home Inspectors
  • Bankers and Mortgage Brokers
  • Insurance Agents
  • Attorneys
  • Contractors

You’ll also need to plan and budget to be able to get a relatively close estimate of how much house you can actually afford. And that might entail prioritizing over other needs, like paying down student loans and taking family vacations. So, before you even start house hunting, write down your priorities.

Establish Your Priorities

When you do start looking at properties, keep in mind that you will most likely be looking at previously-owned homes and that your choices will be limited to what is available in the real estate market. You’ll probably have to compromise on some of the features you would ideally like to have in your new home.

“One of the best things buyers can do during the preliminary stages of the home search is attend open houses to understand value and learn what their money buys,” says Dana Bull, realtor at Sagan Harborside Sotheby’s International Realty. “From there [buyers] will have a better understanding of what their budget can afford and how to frame their expectations.”

First, think about your ideal location — whether that’s a specific neighborhood or just a home close to schools, work, or public transport — and calculate commute times and parking availability. You should also consider the style of house and type of property you’d like to live in — ranch, victorian, a condo, etc.

The age of the house is another important consideration. Older homes may need more updates, which means more money out of pocket, but they could have more personality or unique features you can’t find in modern homes. If you’re considering an older home, just make sure you have the resources to make any necessary upgrades.

Finally, don’t forget about square footage. Consider the amount of space you actually need or want versus what you can afford. Whether you’re looking to downsize or move into a bigger place for your growing family, know what you’re comfortable with before you start house hunting and have a realistic picture of what’s available in your preferred market.

Calculate How Much House You Can Afford

Before you even start looking at properties, the first step in the process should be calculating exactly how much you can afford to pay on your mortgage. Mortgage lenders will use your gross income to make this calculation, but it’s good to know exactly how they decide how much mortgage debt you can take on.

When calculating how much mortgage you can carry, lenders will use a percentage of your monthly gross income (MGI) as a guide. A standard today is the 28%/36% rule, where 28% represents the portion of your gross income that goes to paying housing or mortgage expenses and 36% represents the portion of your gross income that goes to pay all of your other debt obligations. To get a ballpark figure of your monthly mortgage payments, multiply your MGI by the percentage you’re comfortable with, then divide it by 100. For example, if your MGI is $6,000 and you want to use the 28% ratio, multiply 6,000 by 28 (6,000 x 28 = 168,000) and then divide the result by 100, which equals $1,680.

Although 28%/36% are standard percentages, some lenders may use other numbers, with the back end ratio going as high as 43% (or even higher in some cases). It’s a good idea to know what percentages your mortgage lender is using when calculating the loan amount you can qualify for.

Know Your Debt to Income Ratio

Your debt to income ratio (DTI) is another way of calculating how much house you can afford and is a number your lender will take into consideration when evaluating your loan application.

To calculate your DTI, add up all your continuing monthly expenses, then divide that number by your MGI. Say you have a monthly mortgage payment of $1,680 and your other monthly household expenses add up to $1,000, then your total monthly debt will be $2,680. If you divide $2,680 by $6,000 the result will be .44, or a back end ratio of 44%. The higher your DTI, the higher the risk you represent to potential lenders. Most lenders prefer a DTI under 36%.

Knowing this number is also a good way for you to identify areas where you can reduce debt, such as paying down credit card balances. Improving your DTI before starting your home search could help you qualify for a larger mortgage or a lower interest rate.

When adding up your debts, remember to include recurring monthly expenses, such as:

  • Property taxes (if paid monthly)
  • Cell phone bills
  • Credit card payments
  • Daycare costs
  • Insurance payments (medical, home, auto)
  • Rent or house payments
  • Loans (student, auto, etc.)
  • Alimony or child support (or payments made to support a relative)
  • Any other fixed debt you pay on a monthly basis.

Determine Your Down Payment

The absolute minimum down payment you’ll need to purchase a home is 3% to 5% if you’re applying for a conventional loan and 3.5% if it’s an FHA loan. However, the ideal down payment is 20% of the home’s value, and for this you need to start saving as soon as possible. Less than this amount and you will have to add what is called private mortgage insurance (PMI). PMI protects the lender from most if not all losses sustained if the borrower defaults on their mortgage loan, and is required whenever a down payment of less than 20% is made.

The cost of the PMI is included in your monthly mortgage payments, increasing the amount you’ll have to pay. If you can afford to put 20% down, do so. Not having to pay a PMI means a lower monthly payment plus savings on interest over time.

Improve Your Credit Score

Your credit score will be an important component in your home buying journey. A higher credit score will qualify you for lower interest rates, so your first step is to check what your score is and see if there are ways of improving it. Lenders routinely divide credit scores into tiers which determine the interest rates and loan terms afforded to you. If a FICO score is between 700 and 719 it will qualify for one interest rate, while if the score is between 720 and 739 it will qualify for a lower rate. Check your score, and if it is close to a higher tier see if you can improve it enough to qualify for a lower interest rate. If your credit score has room for improvement, consider using a credit repair company, which could increase your score and secure a more favorable rate on your mortgage.

Use a Home Affordability Calculator

As you can see, buying a house entails a whole lot of preparation and calculation. You can run the numbers yourself, or take advantage of a mortgage calculator to understand how much your monthly payment is going to be. Home affordability calculators are also useful because you can input different information, such as down payment amounts, interest rates, and DTI, to see how the numbers change and get a better idea of how much house you can afford using different parameters.

Consider How to Best Allocate Your Assets

You have a certain amount of money to spend on a new home purchase, so figuring out how best to use that money is important. Asset allocation just means you have to decide where your money is best spent — is it in increasing the amount of your down payment, or paying the closing costs out of pocket? Should you buy points to pay interest upfront in exchange for a lower interest rate over the life of the mortgage? Consider all financing options and how they will affect your mortgage over the long run and choose the one that gives you the biggest savings over time.

Plan for Maintenance Costs and Other Expenses

Determining how much house you can afford isn’t the only calculation you need to make when looking for a new home. Consider how home maintenance costs can change. If you have a larger yard than your previous home you may have to hire a gardener or invest in additional equipment if you plan on doing the maintenance yourself. Larger homes can lead to higher heating and cooling costs as well. Make sure you take additional home maintenance costs into consideration when budgeting for a new home purchase.

Don’t forget to budget for moving costs as well. Think about whether this is a move you can do yourself or if you will need to hire professional movers. Get estimates and check out different moving companies beforehand to determine which will work best for you.

Set Up an Emergency Savings Fund

Lenders will require you to have some cash reserves when applying for a mortgage, and how much of a reserve you’ll need will depend on your DTI. The lender may not need a large reserve if your debt-to-income ratio is 36% or less, but if your DTI is over 36%, you’ll likely require a larger reserve.

Many experts recommend having three to six months’ worth of living expenses in your emergency fund should you become unemployed. This fund would be used to pay expenses such as mortgage payments, insurance, loans, utilities, groceries, etc. You should also have a separate emergency fund for home repairs.

It’s generally recommended you have 1% to 3% of your home’s value saved and accessible to use for home repair emergencies. So, if your house is worth $200,000, you should have between $2,000 to $6,000 of cash on hand in a separate account earmarked exclusively for home emergencies.

You can also avoid unexpected expenses by having the home inspected before you purchase it. “A home inspection gives buyers the opportunity to learn about the overall condition of a property and how to maintain it,” says Bull. “If major defects are discovered, the buyer may have the opportunity to renegotiate with the seller.”

She does caution that—although not ideal—buyers in competitive markets are bypassing home inspections to strengthen their offer when there are multiple bids on a house.

COVID-19 and the Home Buying Process

The uncertainty created by the ongoing coronavirus pandemic does not mean you can’t go ahead with your plans to buy a home. Even with lockdowns in place, many sellers and real estate agents are going the video route by offering virtual tours.

Bull says that, although most buyers are not relying solely on virtual tours to buy a house, these tours can help shoppers zero in on homes of interest. Most buyers will want an in-person tour before making an offer but, even if an offer is made based on the virtual tour, “most will include a contingency that allows them to walk away after a home inspection or physical walk through.”

As for consumer protection, the Coronavirus Aid, Relief, and Economic Security (CARES) Act signed into law in April, 2020 contains several provisions for homeowners. Although these measures only apply to those who are currently paying a federally-backed mortgage, many mortgage lenders and states provide relief options for borrowers with other types of mortgages.

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