How Much Should I Spend on a House? 4 Steps to Follow

Shopping for a mortgage, you might encounter lenders who pre-qualify you for a higher loan amount than you expected. Many lenders work with standard debt-to-income ratio calculations which don’t take into account other costs of homeownership. If you take the highest loan amount, you risk maxing out your available funds and becoming “house poor,” without liquidity.  Here are four steps to follow when deciding how much you should spend on a house.

Step 1: Understand what percentage of your income should go toward your mortgage 

Take a good look at your monthly income and expenses. This will help you understand how much you can spend on a house. Keep in mind that you’ll need to account for taxes, insurance, repairs and renovations, along with increased utility expenses. 

Determine your debt to income ratio (DTI). One of the first financial factors a lender will review is your DTI. To determine your DTI, take your gross monthly income before taxes (not your take-home pay) and divide that by the total amount you pay in recurring monthly debt.Be sure to include income and debt for everyone on the loan application including student loans, car loans, credit cards, etc.

Use the 28/36 rule to determine what you can afford. According to this rule, also used by lenders, most people can afford to spend as much as 28% of their gross monthly income on a mortgage and up to 36% on debt payments and still manage other typical recurring expenses.

With a DTI under 33%, you’ll qualify for better terms and interest rates because you represent a low risk of default. The better your DTI, the more confident lenders will be that you’ll stay on track with your payments and pay back the mortgage. 

Step 2: Know all your costs when buying a house

Most conventional loans require 20% as a downpayment, however, sometimes it’s simply not possible to save up a 20% downpayment. To work with a down payment less than 20%, you’ll need to qualify for an FHA, VA, or USDA loan.

Remember the closing costs. Expect to pay between 3-6% of the home’s total purchase price for closing costs. 

Step 3: Project the costs of owning a home 

For renters becoming homeowners, utility bills could bring sticker shock. As a homeowner, you can expect your utility bill to be almost four times higher than what you paid as a renter.

Homeowners need to pay property taxes and insurance. Depending on where you live, your property tax rate will vary.

Private Mortgage Insurance (PMI) pays the lender if you default on your mortgage. It applies to buyers whose down payment is less than 20%.

If you live in a community with a homeowners association (HOA), you will need to pay a monthly fee to the association.

Your home will need repairs and renovations over time so you may want a home maintenance savings fund.

Step 4: How much should you spend on a house? Calculate the “right” amount

A home affordability calculator estimates how much home you can afford. Four main factors are taken into consideration:

  1. Where you live
  2. Your annual income
  3. The amount you’ll apply as a down payment
  4. Monthly recurring debts and spending

Make sure you take some time to understand all costs associated with homeownership – and how they affect one another. Examine your DTI to determine if you can afford a loan at a good rate or be better served by paying off debt first. Then estimate your monthly mortgage payment along with other recurring costs to see how much you should be spending on a house.

Read full article:Redfin.com