Before you snatch a great buy on a home you love, your first question should always be: "What can I afford?" No matter what you want in a home as far as age, style, location or size, you could end up with a beautiful, furniture-less house if your mortgage payments eat up more than half of your income.(To learn about the process of buying your first home, read Top Tips For First-Time Home Buyers.)
Calculate an Affordable Payment
The 43% debt-to-income ratio rule is generally used by the federal housing administration (FHA) as a guideline for approving mortgages. This ratio is used to determine if the borrower has the capacity to repay the mortgage; it often changes depending on market conditions.
All your debt payments plus your new housing expenses - mortgage, home owner's association fees, property tax, homeowner's insurance, etc. - shouldn't equal more than 43% of your monthly gross income.
For example, if your monthly gross income is $4,000, multiply this number by 0.43. $1,720 is the total you should spend for debt payments including housing. Now, let's say you have monthly minimum credits card payments of $120, a car loan for $240 and student loans for $120. By this rule, you have $1,240 per month you can afford for housing.
However, you also need to factor in the front-end debt-to-income ratio (DTI), the monthly debt you will have to incur from housing expenses alone. For example, although this metric is subject to change, during a recession it is usually greater than 30%. For example, if your gross income is $4,000 per month, you would have trouble getting approved for $1,720 in monthly housing expenses even if you have no other debt when the DTI is 31% . Your housing expenses should be under $1,240.
Why wouldn't you be able to use your full debt-to-income ratio if you don't have other debt? Let's say you're debt free because you just paid off your vehicle loan. However, you may trade-in your car and take out a new car loan in six months. If your mortgage is 43% of your income, you'd have no wiggle room for when you want to or have to incur additional expenses.
Factor Budget Items Beyond Debt
You may love to cook with gourmet ingredients, take a weekend getaway every month, drink high-end wine or work out with a personal trainer. None of these relatively extravagant hobbies are budget killers, but they are reasons why you'd have to skip electricity bill payments if you bought a home based on a 43% debt-to-income ratio alone. Before you practice making mortgage payments, give yourself a little financial elbowroom by subtracting the amount of your most expensive hobby from the payment you calculated. If this amount isn't enough to buy the home of your dreams, you may have to cut back on your hobby expenses - or start thinking of a less expensive house as your lifestyle-friendly dream home.
Play House, Financially
Save the proceeds from your current home in a savings account and determine whether or not, after factoring such expenses as car payments, you will be able to afford the mortgage. It is also important to remember that additional funds will have to be allocated for maintenance and utilities. These costs will undoubtedly be higher for larger homes.
If you can handle these extra payments without sweating extra credit card debt, you can afford to buy a home - as long as you have saved up enough money for your down payment.
Don't Buy a Home Based on Future Income
Raises don't always happen and careers change. If you base the amount of home you buy on future income, set up a romantic dinner with your credit cards. You're going to end up with a long-lasting relationship with them.
It's best to put down 20% of your home price to avoid paying private mortgage insurance (PMI). PMI can cost an extra $50 to $100 per month of your mortgage, sometimes more and sometimes less. But a smaller down payment won't cost you buying a home. You can buy a home with as little as 3.5% with an FHA loan.
Bonuses to a larger down payment:
- Smaller mortgage payment. For a $200,000 mortgage with a 5% interest rate for a 30-year term, you would pay $1,074. If your mortgage was $180,000 with a 5% interest rate for a 30-year term, you'd pay $966.28.
- More lender choice. Some lenders won't finance you unless you put at least 5-10% down.
While there are a lot of benefits to a larger down payment, don't sacrifice your emergency savings account completely to put more down on your home. You could end up in a pinch when an unexpected repair arises.
When to Buy a Home
Ideally, you should buy a home in the opposite season from the best activities in your area. Find the nearest tourist area to your locale, and call a hotel and ask when the off season is. This is a great time to buy a home. Another strategy is if you are choosing an area with a lot of families, wait till October after kids are already in school.
Finding the perfect market conditions to buy a home is a little harder and riskier. You could decide to wait to buy a home because prices went up, but then prices go up further and you can no longer afford a home in the area you want. As long as you plan on living in your home for 10-plus years, buy a home when you want to and where you want to, as long as you stick to your affordable payment range.
Planning to Stay Put
If you can't estimate what city you are going to live in and what your 10-year plan is, it's not the right time to buy a home. If you want to buy a home without a 10-year plan, buy a home that is priced much lower than the maximum you can afford. You'll have to be able to afford to take a hit if you have to sell it quickly.
Affordability should be the number one thing you look for in a home, but you also need to stable enough to know you are going to want to live in the home you pick for at least 10 years. If not, you could get stuck in a home you can't afford in a city you're ready to leave.
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