You must take into account more than just finances
If you feel ready to purchase a home, the first question you will likely ask is, "How much can I afford?" And while answering this question requires considering more number of factors.
Learn how to analyze "affordability" prior to purchasing that home that appears to be a bargain. You must consider a variety of factors, including the debt-to-income (DTI) ratio and mortgage rates.
• Determining your debt-to-income ratio (DTI), and more specifically your front-end DTI, is a crucial aspect of obtaining a mortgage.
• Your ability to purchase a home is dependent on the amount of the down payment you can afford.
• When determining if you can afford to purchase a home, you should take into account a variety of financial and lifestyle factors in addition to the price of the property.
• You should also assess the local real estate market, the economic outlook, and the ramifications of your desired length of stay in the area.
• You must also consider your present and future lifestyle needs.
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Understand Your Debt-to-Income Ratio First
Money is the first one and most obvious decision point. If you have enough cash to purchase a home outright, you can certainly afford to do so now. If you qualify for a mortgage on a new home, most experts would agree that you can afford the purchase even if you did not pay cash. But what mortgage amount can you afford?
The Federal Housing Administration (FHA) generally uses a debt-to-income (DTI) ratio standard of 43% when approving mortgages. This ratio determines whether the borrower can make monthly payments. Depending on the real estate market and general economic conditions, some lenders may be more flexible or strict.
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A DTI of 43% indicates that your regular debt payments and housing-related expenses (mortgage, mortgage insurance, homeowners association fees, property tax, homeowners insurance, etc.) should not exceed 43% of your gross monthly income.
For instance, if your monthly gross income is $4,000, you would multiply this number by 0.43 to determine the total amount you should spend on debt payments, which is $1,720. Suppose you already have the following monthly obligations: Minimum payments of $120 for credit cards, $240 for a car loan, and $120 for student loans total $480. Therefore, theoretically you can afford up to $1,240 per month in additional mortgage debt without exceeding the maximum DTI. Obviously, less debt is always preferable.
Illegal is discrimination in mortgage lending. There are steps you can take if you believe you have been discriminated against based on your race, religion, sex, marital status, use of public assistance, national origin, disability, or age. The filing of a report with the Consumer Financial Protection Bureau or the U.S. Department of Housing and Urban Development is one such step (HUD).
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What Mortgage Lenders Want
You must also take into account the front-end debt-to-income ratio, which compares your income to the monthly debt you would incur from housing costs alone, such as mortgage payments and mortgage insurance.
Typically, lenders prefer that this ratio not exceed 28%. Even if you have no other monthly obligations, it would be difficult to obtain approval for $1,720 in monthly housing expenses with a monthly income of $4,000. For a front-end DTI of 28%, your housing expenses must be less than $1,120.
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Why wouldn't you use your entire debt-to-income ratio if you have no other debt? Because lenders dislike borrowers who live on the edge. Financial misfortunes occur—you lose your job, your car is totaled, or you suffer a temporary disability that prevents you from working. If your mortgage is 43% of your income, you would have no wiggle room to incur additional expenses when you want to or need to.
The majority of mortgages are long-term contracts. Consider that you could be making these monthly payments for the next 30 years. Consequently, you should evaluate the dependability of your primary income source. You should also consider your future prospects and the probability that your expenses will increase over time.
Being approved for a mortgage up to a certain amount does not guarantee that you can afford the payments, so be truthful about the level of financial risk you are willing to assume.
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Can You Afford the Down Payment?
To avoid paying private mortgage insurance, it is best to make a 20% down payment (PMI). PMI is typically added to monthly mortgage payments and can increase them by $30 to $70 per $100,000 borrowed.
There may be several reasons why you would not want to make a 20% down payment. You may not intend to live in the home for an extended period of time, have long-term plans to convert the home into an investment property, or don't want to take the risk of putting that much cash down. If this is the case, purchasing a home without a 20% down payment is still possible. FHA loans, for instance, allow for as little as a 3.5% down payment, but there are advantages to contributing more. In addition to the previously mentioned benefit of avoiding PMI, a larger down payment also results in:
• Lower mortgage payments; a $200,000 mortgage with a 4% fixed interest rate and a 30-year term would cost $955 per month. A $180,000 mortgage with a 4% interest rate and a 30-year term would cost $859 per month.
• More lender options; some lenders won't offer a mortgage without a 5% to 10% down payment.
It is not nearly as important to be able to afford a new home today as it is to be able to afford it in the long run.
While there are numerous advantages to a larger down payment, you should not completely deplete your emergency savings to make a larger down payment. When unexpected repairs or other needs arise, you may find yourself in a tight spot.
You can also read our other article about Understanding Mortgage Closing Expenses
The Housing Market
Assuming you have your finances under control, your next consideration should be the economics of the housing market in your current location or the area to which you plan to relocate. A home is a costly investment. Possessing the funds to make the purchase is a plus, but it does not answer the question of whether the purchase makes financial sense.
One way to do this is to determine whether renting is less expensive than buying. If purchasing is less expensive than renting, this is a powerful argument in favour of buying.
Similarly, it is important to consider the long-term effects of a home purchase. For generations, purchasing a home was virtually a guarantee of financial success. Your grandparents could have purchased a home for $20,000 fifty years ago and sold it for five to ten times that amount thirty years later. Real estate has traditionally been regarded as a safe long-term investment; however, economic downturns and natural disasters can put this theory to the test and cause prospective homeowners to reconsider.
During the Great Recession, many homeowners lost money during the real estate market crashed in 2007 and ended up owning homes that were worth significantly less than the purchase price for a number of years. If you are purchasing the property with the expectation that its value will increase over time, you must include the cost of mortgage interest payments, property upgrades, and ongoing or routine maintenance in your calculations.
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The Economic Outlook
Similarly, there are years in which real estate prices are abnormally low and years in which they are abnormally high. If prices are so low that it is evident that you are getting a good deal, it may be a good time to make a purchase. In a buyer's market, low prices increase the likelihood that time will work in your favour and cause your home's value to rise over time. For instance, if history repeats itself, the COVID-19 pandemic and its dramatic impact on the economy could cause a decline in home prices.
Interest Rates
Interest rates, which play a significant role in determining the size of a monthly mortgage payment, have both high and low years, the latter of which is preferable. A 30-year mortgage (360 months) on a $100,000 loan with a 3% interest rate would cost $422 per month. At 5% interest, the monthly payment will be $537. It increases by 7% to $665. If interest rates are falling, it may be prudent to delay a purchase. If they are increasing, it makes sense to buy sooner rather than later.
Time of Year
The seasons can also play a role in the decision-making process. Spring is likely the best time to shop if you want the greatest selection of available homes. A portion of the reason relates to the target market for the majority of homes: families who are waiting to move until their children complete the current school year but want to be settled before the fall semester begins.
Winter (especially in colder climates) or the height of summer (in tropical states) may be a better time to look for a home if you want sellers who may be seeing less traffic, which may make them more flexible on price (the off-season for your area, in other words). It is unlikely that sellers will receive multiple offers during this time of year, as inventories are likely to be low and there will be fewer options available.
It is important to note, however, that some savvy buyers prefer to make offers around holidays, such as Christmas or Easter, in the hopes that the unusual timing, lack of competition, and overall spirit of the season will result in a quick sale at an affordable price.
Consider Your Lifestyle Needs
Although money is a significant factor, there are numerous other variables that could impact your timing. Are you about to have a baby, or do you have an elderly relative who cannot live alone? Does the move require your children to switch schools? If you're selling a home you've lived in for less than two years, would you be subject to capital gains tax, and if so, would it be worthwhile to wait to avoid the sting?
You may enjoy cooking with gourmet ingredients, taking monthly weekend trips, appreciating the performing arts, or working out with a personal trainer. None of these habits are budget-busters, but if you purchased a home with a debt-to-income ratio of 43%, you may have to forego them.
Before practising making mortgage payments, give yourself some financial wiggle room by deducting the cost of your most expensive hobby or activity from the calculated payment. If the balance is insufficient to purchase the home of your dreams, you may need to make sacrifices or consider a less expensive home as your dream home.
Selling a home and purchasing another
If you are selling a home and planning to purchase another, place the proceeds in a savings account and determine whether or not you will be able to afford the mortgage after accounting for other necessary expenses such as car payments and health insurance. In addition, additional funds will be allocated for maintenance and utilities. Larger homes will undoubtedly incur higher costs.
When calculating, use your current income and do not assume you will earn more in the future. It is not always possible to receive a raise, and careers can change. If you purchase a home based on your expected future income, you might as well plan a romantic dinner with your credit cards, because you will end up in a long-term relationship with them. However, if you can manage these additional house costs without incurring additional credit card debt, you can afford to purchase a home—as long as you have saved enough for a down payment.
Do You Plan to Stay?
Prioritize affordability when searching for a home, but also consider the length of time you plan to reside there. If you don't, you could be stuck in an unaffordable home in a city or town you wish to leave. As a rule of thumb, many financial experts recommend living in a home for five years before selling it. Do not overlook the costs associated with buying, selling, and moving. Also consider the mortgage breakeven point associated with the home you are selling. It may not be the right time to purchase a home if you are unable to decide where you will live and what your five-year plan is.
If you want to buy a home without a five-year plan, you should purchase one that is significantly less expensive than the most you can afford. You must be able to afford to take a loss if you must sell the item quickly. If you work for a company that buys the homes of relocated employees, this is known as a guaranteed buyout option.
How Much House Can I Afford?
Determine how much house you can afford by analysing your income, savings (for a down payment and closing costs), and recurring debt. The 43% debt-to-income (DTI) ratio standard is a good guideline for mortgage loan approval and affordability.
How Does Buying a House Work?
Buying a home is typically one of the most significant purchases you will make in your lifetime. When you find a house you want to purchase, you should first determine if you can afford it. Next, you should ask your lender for a pre-approval letter, which indicates that the lender believes you are likely qualified for a mortgage loan. If the seller accepts your offer, you will be required to take a number of additional steps, including making a down payment and obtaining mortgage loan approval from an underwriter and lender.
What Is the Rule of 28/36?
Underwriters and lenders use the 28/36 rule to determine if you can afford the home you wish to purchase. In general, this rule is regarded as one of the most accurate methods for determining how much mortgage payment debt you can afford based on your income.
In order to be approved for a mortgage, many lenders stipulate a maximum household expense-to-income ratio of 28% and a maximum total debt-to-income ratio of 36%.
The Conclusion
Are you prepared to purchase a home? Yes, if you have the means to do so. But "afford" is not as simple as the amount of money in your bank account. A variety of additional financial and lifestyle factors should be factored into your calculations.
When all these factors are considered, "if you can afford to do it" becomes more complicated than it initially appears. However, considering financial factors before making a purchase can prevent costly errors and future financial issues.
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