Introduction:
If you are in the market to buy a home, the most important question you should ask yourself is “How much house can I afford?” This is especially important because the bank may approve a loan higher than what you can comfortably pay. There are many factors that can influence your ability to purchase a home. Understand these factors so you can determine the appropriate financial value of the home you can buy.
Determining Your Home Affordability:
There are several ways to determine your home affordability:
1. Debt-to-Income Ratio: The 28/36 Rule
2. Your Credit Score
3. Down Payment Amount
4. Other Costs to Consider
How to Evaluate Your Budget?
First, calculate the maximum monthly payment you can afford, as this figure can determine the maximum price of the home you can buy. For example, if your monthly income is $67,521 and you have no debt, you can afford a monthly payment of $1,575 using the 28/36 rule.
Next, establish a more conservative estimate based on the 25% rule. Continuing with the previous example, this monthly payment would be estimated at $1,407. But if you are obligated to pay $100 to the homeowners’ association and want to save $200 a month for home repair expenses, that translates to you being able to afford a monthly payment of $1,107.
These two figures – $1,407 and $1,575, in our example – provide you with a minimum and maximum limit on the amount you may be able to afford. You can then use a mortgage calculator to generate a total mortgage amount. This information will give you a target price range for the home you can confidently afford.
Debt-to-Income Ratio: The 28/36 Rule
Banks use your debt-to-income ratio (DTI) to determine the maximum price of the home you can buy. It uses the monthly debt-to-income ratio to determine the maximum monthly mortgage payment you can afford, from which the amount of mortgage you can handle is derived.
Your debt-to-income ratio is calculated by dividing your total monthly income by your total monthly debt payments. For example, if you earn $2,000 a month before taxes and pay $200 in student loans, your debt-to-income ratio would be 10% ($2,000 / $200 = 10).
There are various mortgage programs; each has specific rules regarding the maximum allowable debt-to-income ratio for qualification. Generally, many banks use the 28/36 rule, which is as follows:
– No more than 28% of your income should go towards your mortgage payment.
– No more than 36% of your income should cover total debt payments, including the mortgage payment.
If you are paying 10% of your income in debt fees, you would be able to afford a monthly mortgage payment of 26% of your income (36% – 10%). However, if you have no debt at all, you could afford a mortgage payment up to 28% of your income.
Note: Some loan programs allow a debt-to-income ratio of up to 50% for all combined debt instead of 36%. But remember, this means you are more likely to be “house poor,” meaning there may not be much left for you to spend each month after paying your home payments.
Impact of Credit Score:
Banks use your debt-to-income ratio to determine the maximum price of the home you can buy. One variable that affects this calculation is your credit interest rate, which has a significant impact on your ability to afford a more expensive home.
It translates
A good credit score leads to a lower interest rate. This means you don’t pay much to the bank, and therefore you can be approved for a more expensive home. Conversely, a lower credit score leads to a higher interest rate, which can mean a more expensive loan and a lower approval amount.
Down Payment Amount:
The down payment amount also affects how much home you can buy. Most banks offer traditional loans with private mortgage insurance (PMI) for down payments ranging from 5%-15%. However, you may qualify for an FHA loan with a minimum down payment of 3.5%.
Down payments do more than enable eligibility for certain loans – they reduce the amount you pay on the loan. The larger the down payment, the more benefits you gain in the long run. For example, if you have a good to excellent credit score, a 30-year mortgage loan of $200,000 at an interest rate of 2.35% with no down payment would result in you paying $78,903 in interest plus your PMI.
The same loan with a 20% down payment of $40,000 would reduce the total amount of interest you pay to $63,123. With the same down payment and mortgage amount, you could switch to a 20-year mortgage loan and pay only $40,688 in interest.
Other Costs to Consider:
Home buying costs are not just mortgage payments; they also include:
– Homeowners Association fees
– Property taxes
– Home upgrades
– Home insurance
– Maintenance and repairs
Most financial experts recommend keeping all these monthly expenses (including mortgage) within 25% of your income.
Frequently Asked Questions:
– How much can I qualify for a mortgage?
– How does a mortgage work?
– How much can I afford for a home with a $60,000 annual salary?
Source: https://www.thebalancemoney.com/how-much-home-can-you-afford-to-buy-1798237
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