You’re likely aware that homes these days cost astronomical sums, with the median home price nationwide hovering at $375,000—an increase of 10% from a year earlier.
Daunting? For sure. Yet if you’re pondering a home purchase right about now, the more important number to know is this: How much home can you afford?
The answer to this question is all the more critical in today’s red-hot, warp-speed market, where you won’t stand a chance without a clear picture of your finances. If all you have is a hazy idea of what you can pay, home sellers will have a hard time taking you seriously. Worse yet, you might get swept up in a bidding war on a home and win—only to find out afterward that you’ve committed to a price beyond your means. Yikes!
“Head into a house hunt with your numbers in hand. Know your top number,” says Jay Zigmont, certified financial planner and founder of Live, Learn, Plan. “If you can afford a $250,000 house, don’t look at $300,000 houses. You will by nature like the $300,000 houses better and start rationalizing spending more.”
Here’s how to get a handle on your homebuying budget so you can find home that’s priced just right for you.
How large a mortgage can you afford?
While most homeowners will make a sizable down payment on a house (typically 3.5% to 20% of the property’s price), the rest of the money is typically borrowed in the form of a mortgage, which is paid back to the lender every month, plus interest, for up to 30 years.
“Banks commonly allow up to 28% of your gross income before taxes as your monthly house payment,” says Zigmont.
Let’s say, for instance, that every month you’re pulling in $6,000 before taxes. That means $1,680, or 28%, is the maximum amount that can go toward monthly housing payments. Keep in mind that this should include not just your mortgage, but all housing expenses, including property taxes, home insurance, and mortgage insurance (if you have it), many of which get rolled into your monthly payments.
What is debt-to-income ratio?
While up to 28% of your income can go toward housing, this is likely not the full picture, since you might have other debts such as credit cards or college loans. Your overall debts, compared with your income, define your debt-to-income, or DTI, ratio.
To figure out your debt-to-income ratio, tally up how much you pay monthly toward debts like car payments, credit cards, and student loans. Once you have that number, divide that amount by your monthly income.
So just how high should a DTI ratio go when you buy a home?
“Lenders usually look for a debt-to-income-ratio of 36% or less when underwriting your loan,” says certified financial planner Anthony Carlton, who’s also vice president and wealth adviser at Farther Finance. This means that all your debts, including a house payment, should total no more than 36% of your pre-tax income.
Why mortgage pre-approval is a good idea
Since lenders won’t loan you more money than they think you can easily pay back, pre-approval is a good way to gauge what home price you can pay. Another nice bonus is that a pre-approval letter shows home sellers you’re serious and can follow through on your offer—an important edge if you’re bidding against other buyers who haven’t taken this step.
That said, no matter how much money a lender is willing to loan you, keep in mind that you know your finances best. Run your own numbers, taking into account not just your income and debts, but also every possible expense or potential scenario you see coming down the pike.
Read full article:Realtor.com