Everyone enjoys browsing the real estate listings and circling the homes they would like to own. But it can get frustrating when you see some of the prices of homes today, particularly in or around major cities such as New York, Los Angeles or Boston.
Before you venture out and start looking at homes, you should try to get a reasonably good idea of how much home you can afford. This will be based on three primary factors:
1. How much money you have available for a down payment and for closing costs
2. The loan amount your lender will approve
3. How much you can spend on mortgage and interest payments
Typically, the down payment will be anywhere from 5 to 20 percent of the total purchase price of a home. Closing costs will generally run you somewhere between 2 and 6 percent. What Are Mortgage Loan Closing Costs?
When you apply for a mortgage, lenders will look at your credit reports, income, and various other factors before determining how much they will approve as a loan.
But it is the amount of your monthly payments, however, that will ultimately decide how much home you can afford. The general rule of thumb is that your mortgage payments should not exceed 28 percent of your income. Your entire debt-to-income ratio, which includes all recurring debt, including mortgage, car loan, and credit card payments, should not exceed 36 percent of your income. Find out more about Debt to Income Ratio for Mortgage Loans.
Let us assume that you have an annual household income, including interest and dividends, of $80,000, or $6,667 per month. Now let us suppose that you are interested in buying a home that costs $250,000. If you are able to put down 10 percent ($25,000), you will need a mortgage of $225,000. But will you be able to afford the payments? Let’s do the math.
If you are approved for a 30-year fixed interest loan of $225,000 at 5.75 percent, your monthly payment, including interest, would be roughly $1,340. That is about 20 percent of your regular monthly income — well under the 28 percent figure. If we assume your car payments and other recurring debt is around $800 per month, your total recurring monthly payments are $2,140 — again, well under the 36 percent mark. You’re in luck: you can afford the house.
There are plenty of online calculators that will help you determine how much you can afford to pay each month. But knowing ahead of time what you can afford to spend will make you a better-informed, smarter home and mortgage shopper.