So you've picked out some locations you're interested in and thought about the style of home that suits you best. Now it's time for some planning of the less fun variety. Before you start looking at houses and, somewhat counterintuitively, before you start shopping for a loan, you need to figure out how much home you can afford. (For background reading, see Mortgages: How Much Can You Afford?)
Why Do It Yourself?
The reasons for doing your own affordability calculations are twofold. First, you don't want to look at houses you can't afford. This will give you unrealistic expectations about the type of home you want to live in and will make homes that actually fall in your price range look less appealing. It's better to start looking at the bottom of your price range or even below your price range and work your way up. That way, you'll really appreciate what say, $300,000 can get you that $250,000 can't.
Second, you want to do your own math because the bank may say you can afford more house than you would actually be comfortable paying for. While the bank will ask for very detailed financial information when you apply for a mortgage, it will not know the amounts of quite a few costs that eat away at your disposable income, like what your monthly grocery expenses are, how much you spend on gas, what your health insurance premium is, if you're diabetic and have high ongoing medical costs, what your water bill is and how much you spend on entertainment.
What the bank will know about are your monthly debt payments (like credit cards and student loans), the four major components of your home payment (property, interest, taxes and insurance) and any amounts you are legally obligated to pay (like child support or alimony). You want to make sure you don't borrow more than you can actually afford based on the bank's partial picture of your financial situation. (Buying too much house is one of the most common financial mistakes. Find out which others to avoid in Top 6 Most Common Financial Mistakes.)
The following steps will break down what may seem like a daunting process so that you can easily figure out how much you can afford to spend per month on your home.
- Figure out your household's take-home pay after tax.
What do you and any other income-earners who will be contributing to the household bills bring home each month after tax? Look at your last pay stub, ask your HR department or use an online paycheck calculator to get this amount. This is how much money you currently have to spend each month. The good news is that this amount will actually increase with your homeowner tax breaks. (To learn more, read Insurance Tips For Homeowners.)
Make a list of your household's recurring monthly expenses.
This should include bills you pay every month, like the electric bill, and bills you only pay some months, like car insurance. If you don't already have a budget where you've been keeping track of these expenses, look at your checkbook, bank statements and credit card statements to help you figure out what you've been spending. Note which expenses are necessary (like the electric bill), which are totally optional (like going out to eat for fun and buying new clothes for fashion's sake) and which are necessary but flexible (like your phone and grocery bills).
Make a list of the expenses that you will add when you become a homeowner.
These expenses will vary depending on the type of home you purchase. In a condo or townhouse, you will most likely have to pay monthly homeowners' association fees, which will cover things like landscaping of common areas, upkeep of indoor common spaces (like hallways, stairwells, and elevators), upkeep of recreational areas (like pools or clubhouses) and water, sewer and garbage costs. In a house, expenses you'll have that you don't have as a renter include water, trash and home maintenance. In any type of property, you'll pay property taxes and hazard insurance and if you're moving farther from your job, your transportation costs may increase. (For more on costs you may not have considered, see 4 Overlooked Homeownership Costs.)
It can be hard to estimate these expenses accurately when you're not familiar with how they are calculated, but if you can get some answers from people who live in your target neighborhood, from a real estate agent who is familiar with your target neighborhood or by making a few phone calls to city agencies and insurance companies, you can get a reasonable idea. Also, if you're going to make a down payment of less than 20%, you'll need to factor in the monthly cost of private mortgage insurance (PMI). Remember, it's best to estimate high when planning your budget to be on the safe side. (For more on this cost, see Outsmart Private Mortgage Insurance and 6 Reasons To Avoid Private Mortgage Insurance.)
Figure out what expenses will go away.
For example, if you're paying renters insurance, you'll be able to cancel that. If you're planning to cut back on certain fun activities (like going out to eat or an adult education class that isn't related to your career) in order to free up more funds for the house, note these as well. If you're moving closer to work, your gas costs will go down.
Determine how much you have left after expenses to spend on housing.
Once you know what you take home and what you spend each month (excluding your current rent payment), determine how much you have left over each month to spend on housing. When you make this calculation, don't forget to leave room to save for emergencies, retirement and whatever else you want to have money saved up for. In other words, count savings as a non-negotiable "expense."
Figure out how much house you can buy.
An easy way to do this yourself is to play with mortgage payment calculators online (see Investopedia's Mortgage Calculator) to figure out the purchase price you can afford based on the monthly payment at different interest rates. Take today's rate for your geographic area and your loan type and calculate your payment for 0.5% above and below that rate. If today's rate is 6.5%, calculate what you can afford at 6%, 6.5%, and 7%. (For insight on the importance of a good rate, see Got A Good Mortgage Rate? Lock It Up!)
Interest Rate Breakdown
Interest rates fluctuate multiple times a day and the interest rates available at the time you actually purchase your home will affect how much house you can afford. The higher the purchase price, the bigger the difference the interest rate will make. The lower the interest rate, the more expensive the house you can afford, and the higher the interest rate, the less expensive the house you can afford. Here's a chart showing how this works:
|Purchase Price||Interest Rate||Loan Term||Monthly Payment (Principal and Interest)|
Now that you've figured out on your own what you can afford, it's time to apply for a loan.Buying A Home: Get Preapproved For A Loan
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