Are you ready to buy a house? Well, answer that question with another question – namely, your "What can I afford?" And answering that may not be so easy. Before you snap up that seemingly great buy on a home, learn how to really analyze what "affordability" means.
Your Debt-To-Income Ratio
The first, and most obvious, decision point involves money. If you have sufficient means to purchase a house for cash, then you certainly can afford to buy one now. Even if you can’t pay in cash, most experts would agree that you can afford the purchase if you can mortgage a new home. But what sort of mortgage can you afford?
The 43% debt-to-income ratio (DTI) standard is generally used by the Federal Housing Administration (FHA) as a guideline for approving mortgages. This ratio is used to determine if the borrower can make his payments each month; some lenders may be more lenient or more rigid, depending on the real estate market and general economic conditions. A 43% DTI means all your regular debt payments, plus your new housing-related expenses – mortgage, mortgage insurance, 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, you multiply this number by 0.43. $1,720 is the total you should spend on debt payments. Now, let's say you already have these monthly obligations: minimum credit card payments of $120, a car loan payment of $240 and student loan payments of $120 – $480 in all. That means theoretically you can afford up to $1,240 per month in additional debt for a mortgage, etc., and still be within the maximum DTI. Of course, less debt is always better.
What DTI Lenders Want
You also need to consider the front-end debt-to-income ratio, which calculates your income vis-à-vis the monthly debt you would incur from housing expenses alone. Usually, lenders like that ratio to be no more than 28%; during a recession, they might let it slide to as much as 31%. 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 obligations. For a front-end DTI of 31%, your housing costs 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? Basically, because lenders don't like you living on the edge. Financial misfortunes happen – you lose your job, your car gets totaled. 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.
This is why financial planning experts agree that you can afford the home purchase if you can mortgage with a monthly payment that is no more than 28% of your gross income. Just keep in mind that you may need to make that payment every month for the next 30 years. Accordingly, you should evaluate the reliability of your primary source of income. You should also consider your prospects for the future and the likelihood that your expenses will rise over time. Being able to afford a new house today is not nearly as important as your ability to afford it over the long haul.
Needless to say, being able to afford a house doesn't answer the question of whether now is a good time for you to act on that option.
(For additional help, see "Buying A Home: Calculate How Much Home You Can Afford.")
The Housing Market
Assuming you have your personal money situation under control, your next consideration is housing-market economics – either in your current market or where you plan to move. A house is an expensive investment. Having the money to make the purchase is great, but it doesn’t answer the question of whether or not the purchase makes sense from a financial perspective. One way to do this is to answer the question “Is it cheaper to rent than to buy?” If buying works out to be less expensive than renting, that's a strong argument in favor of purchasing.
Similarly, it’s worth thinking about the longer-term implications of a home purchase. For generations, buying a home was almost a guaranteed way to make money. Your grandparents could have bought a home 50 years ago for $20,000 and sold it for five or 10 times that amount 30 years later. The same can’t be said for homeowners of more recent vintage. Many of them lost money when the real estate market crashed back in 2006, and many more now own homes that are worth far less than the price they were purchased at just a decade ago. If you are buying the property on the belief that it will rise in value over time, be sure to factor in the cost of interest payments on your mortgage, upgrades to the property and ongoing, routine maintenance into your calculations.
(Take a look at "To Rent Or Buy? The Financial Issues" for more insight.)
The Economic Outlook
Along those same lines, there are years when real estate prices are depressed and years when they are abnormally high. If prices are so low that it is obvious you are getting a good deal, you can take that as a sign that it might be a good time to make your purchase. In a buyer’s market, depressed prices increase the odds that time will work in your favor and cause your house to appreciate down the road.
Interest rates, which play a large role in determining the size of a monthly mortgage payment, also have years when they are high and years when they are low. Obviously, lower is better. For example, our Monthly Mortgage Payments Calculator shows that a 30-year mortgage (360 months) on a $100,000 loan at 3% interest will cost you $421.60 per month. At a 5% interest rate, it will cost you $536.82 per month. At 7%, it jumps to $665.30. So if interest rates are falling, it may be wise to wait before you buy. If they are rising, it makes sense to make your purchase sooner rather than later.
The seasons of the year can also factor into the decision-making process. If you want the widest possible variety of homes to choose from, spring is probably the best time to shop. “For Sale” signs tend to spring up like flowers as the weather warms and lawns turn green. The reasons are obvious, especially when you consider families waiting to move until their kids finish the current school year, but want to get settled before the new year starts in the fall.
If you want sellers who may be seeing less traffic – which could make them more flexible on price – winter may be better for house-hunting (especially in cold climates), or the height of summer for tropical states (the off-season for your area, in other words). Inventories are likely to be smaller, so choices may be limited, but it is also unlikely that sellers will be seeing multiple offers during this time of year. Some savvy buyers also like to make offers around holidays, such as Christmas or Easter, hoping that the unusual timing, lack of competition and overall holiday cheer will get a quick deal done at a good price.
Consider Your Lifestyle Needs
While money is obviously an important consideration, there are a host of other factors that could play a role in your timing. Is a need for extra space imminent (a new baby on the way, an elderly relative who can't live alone)? Does the move involve your kids changing schools? (Get ready to join the spring house-hunting crowds.) If you'll be selling a house in which you've lived for less than two years, would you incur capital gains tax – and if so, is it worth waiting to avoid the bite?
You may love to cook with gourmet ingredients, take a weekend getaway every month, patronize the performing arts 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 fun and games – or start thinking of a less expensive house as your dream home.
(For details, see "Avoid Capital Gains Tax on Your Home Sale.")
Selling One Home For Another
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.
When you calculate, use your current income. Don't assume you'll be making more money down the road. 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.
Can You Afford the Down Payment?
It's best to put down 20% of your home price to avoid paying private mortgage insurance (PMI). Usually added into your mortgage payments, PMI can cost an extra $50 to $100 per month. 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 larger down payment:
- Smaller mortgage payments. 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.
Do You Plan to Stay Put?
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. 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.
The Bottom Line
Are you ready to buy a house? The flip answer (no pun intended) is “yes if you can afford to do it.” But "afford" isn't as simple as what's in your bank account right now; a host of other financial and lifestyle considerations should figure into your calculations. When you factor in all these elements, “if you can afford to do it” starts looking more complicated than it first appears to be. But considering them now can prevent costly mistakes and financial problems later. Of course, there is one best time to pounce: When you find the perfect house in the perfect place for sale – at a perfect price.