There are a lot of unknowns when it comes to homeownership, particularly for first-time buyers. That's why it is critical to purchase an affordable house. But what constitutes affordable will differ from one buyer to the next. Figuring out the sweet spot requires more than getting a pre-approval letter from a mortgage lender.
At last count, the median price for a new home was more than $300,000, amounting to one of the largest purchases many will make. First-time buyers tend to shop on what the mortgage lender says they can afford, not taking into account other expenses. That sets them up for financial hardship and even a potential foreclosure if they can't afford the monthly payment. (See also: First-Time Homebuyer's Guide.)
The 25% Rule Can Get You Started
One of the easiest ways to calculate how much home you can afford is the 25% rule, which says that your mortgage shouldn't be more than 25% of your income each month. If you have other debts, add them to the mortgage payment to determine how much you can afford. The Federal Housing Authority says that consumers can afford 29% of their gross income for their house. That jumps to 41% if they are living debt free.
Mortgage lenders look at a prospective borrower's debt-to-income ratio when determining if they will lend the money. If it's above 43%, a would-be borrower, in theory, would be denied. But according to the Federal Housing Authority, many lenders are willing to look past a 43% debt-to-income ratio. Let's say your monthly mortgage payment is $1,000 a month and your other expenses are $1,000 – your monthly debt payment would be $2,000. With gross income of $6,000, your debt to income ratio would be 33%. If that ratio is too high, you may need to look at cheaper properties. (For more, see: What's Considered a Good Debt-to-Income (DTI) Ratio?)
Expenses Beyond the Mortgage Need to Be in the Equation
Getting pre-approved for a home loan is an important first step in the homebuying process, but it is only one consideration. First-time buyers have to figure out all the costs associated with homeownership upfront and over time to determine just how much house they can afford. After all, a home mortgage isn't the only recurring expense. There's the homeowners insurance, maintenance costs, utilities and repairs. Consider maintenance alone. The lawn needs to be cut, the snow has to be shoveled and the leaves raked. They all require an upfront investment. Add a lawn service into the equation, and it's an additional monthly expense. Then there's heating and cooling, water and entertainment, not to mention those unexpected repairs that catch homeowners off guard. Prospective homeowners also have to consider home insurance and taxes.
All of those costs, as well as the other daily outlays, have to be included when determining how much home you can afford. Those expenses can add greatly to the monthly outlays, making a home that seemed affordable on paper pricey in reality. A $1,500-per-month mortgage payment may be palatable, but add $1,500 in monthly expenses, and it just got a lot more expensive. (See also: 11 Hidden Costs of Owning a Home.)
Down Payment Should Dictate the Purchase
In order to avoid private mortgage insurance (PMI), homebuyers have to put at least 20% down on their home purchase. With a down payment below that amount, their mortgage payment will go up by anywhere from 0.3% to 1.2% of the loan amount. How much you pay in PMI will depend on the size of the home, your credit score and the potential for the property to appreciate, among other things. If you can't swing $60,000 down on a $300,000 home, shoot for at least 10%. The more of a down payment, the less interest you'll pay over the life of the loan, and the smaller your monthly mortgage payment will be, even if you are hit with the mortgage insurance.
The amount you saved for the down payment should also weigh on the house you buy. If you have enough to put 20% on one home but 10% on another, the cheaper home will give you more bang for your bucks. First-time buyers also have to set aside money for the closing costs, which can amount to between 2% and 5% of the purchase price, depending on which state you live in. If you are purchasing a $200,000 home, you could pay between $4,000 and $10,000 in closing costs alone. The less you have to finance in the loan, the lower interest you will pay over the life of the loan, and the sooner you'll see a return on your investment. (For more, see: How Long Should It Take to Save for a Down Payment?)
Choose a Property You Can Handle
First-time buyers have a lot of wants, often more than they can actually handle. A quaint home sitting atop a picturesque hill may be a dream come true, but shoveling during the winter months could be a costly nightmare, just like that 3,000-square-foot fixer-up is super cheap until you start renovating every room in the house. When considering the affordability of the home, first- time buyers have to consider the state of the property and the size. After all, large isn't always good, especially if heating and cooling it breaks the budget.
Homeownership is still the American dream for many, but it can quickly turn into a nightmare if you purchase the wrong home. First-time buyers have to make sure that the house they purchase is affordable by considering more than just the monthly mortgage payment. Without some upfront calculations, they can find themselves house rich but cash poor, leading to all sorts of financial pain. (For additional reading, check out: First Time Homebuyer's Guide.)