Once you’ve decided you want to be a homeowner, you must determine how much house you can afford. There are two parts to this. The first is to follow a budget for at least three to six months so you know your spending habits and how much money you have to work with for your monthly payment. The second is to figure out how much you can honestly afford to borrow. Mortgage lenders want you to take out the biggest loan possible; your goal is to take out the smallest loan possible.
To estimate how much you can expect to borrow, use the two basic guidelines that banks and mortgage companies follow. Their main guideline is that principal, interest, taxes, and insurance (PITI) shouldn’t exceed a set percent of your gross income (your pay before taxes), and they may set that as high as 30 to 40 percent. Let’s say that your gross income is $50,000 a year ($4,167 per month). Your principal, interest, property taxes, and insurance shouldn’t exceed $15,000 per year (with a 30 percent limit) or $1,250 per month using lender standards. However, you might want to consider how much of your net income (after taxes and deductions—your actual paycheck) you can afford to put toward housing. If your monthly after-tax income is $2,917 (70 percent of your gross income, for example), that mortgage payment takes up 43 percent of your net income every month.
Property taxes can vary drastically between states and even between towns in the same state. You can call the town or city tax assessor and ask what the typical taxes would be on a house that’s in your approximate price range. Most states also offer online property tax estimators; find those by searching for “property tax estimator city state,” with the area you’re looking into. The sales listing for a home you’re looking at may also yield some historical information—but that will change moving forward. Keep in mind that property taxes increase periodically, and that can increase your monthly mortgage payment, too, even if you have a fixed-rate loan.
Your debt-to-income ratio, or DTI ratio, measures the percentage of your gross income that goes toward paying debt. Most financial experts and lenders recommend keeping your DTI ratio under 36 percent of your gross income, but some lenders will let your DTI ratio be as high as 43 percent. You can calculate your DTI ratio by dividing your total monthly debt payments by your gross income.
What counts as debt here?
Total up your monthly debt payments, then divide that number by your monthly gross income. For example, if your total debt payments come to $2,600 and your monthly gross income is $6,250, your DTI ratio would be 41.6 percent.
20 Percent Down Payment
Saving up for a full 20 percent down payment helps your finances in several ways. You’ll get a better deal on your mortgage, you’ll have a big chunk of equity from the start, and you won’t be bothered with PMI, to name just a few of the financial benefits.
Play around with an online mortgage calculator that will help you determine how much you can afford to pay for a house. Mortgage Calculator (www.mortgagecalculator.org) has an excellent calculator for this. You can also find home and mortgage affordability calculators on websites like Zillow (www.zillow.com) and Dave Ramsey (www.daveramsey.com).
Before you start looking at houses, arm yourself with a mortgage preapproval letter from your lender. Sellers love preapproved buyers. That written thumbs-up from the lender shows the seller that you’re serious about buying their house, that you’ve already figured out how much house you can afford and how much money you can realistically borrow. Plus, it benefits you as much by speeding everything up once you’re ready to make an offer.
You’ll need to present a heap of paperwork to the mortgage company during the application process, which may include:
Once you’ve found the house you want to buy, the next step is to make a bid. The bid will include the amount you are willing to pay for the house, the amount you will need to finance, and the time frame needed for the purchase. It would be wise to prequalify for the mortgage amount you feel you will need for the purchase so the seller knows you will most likely get the financing you require.
Should the seller agree to the terms of the bid, the formal contract process will begin. It is common practice at this point for the prospective buyer to arrange for a home inspection of the premises from a qualified home engineer. This way you can determine if the “guts of the place” are sound (the heating, electrical, and plumbing systems, the foundation, roofs, walls, ceilings, etc.). It would be wise to accompany the home engineer on the inspection so you can ask whether certain problems are due to normal wear and tear or are serious problems that the seller must address in the contract of sale.
The real estate contract should contain a few standard clauses, such as a list of whether certain items (window treatments, lighting fixtures, air conditioning units) are to remain on the premises after closing. In addition, the contract should contain confirmation that the heating, electrical, and plumbing systems, as well as all appliances, will be in working order for closing. All contracts should be conditioned upon two things: your ability to secure a specific amount of financing within a predetermined time period and the seller’s ability to deliver a clean title.
There is also the matter of the earnest money (which can range from $1,000 to 10 percent of the home price) that must be paid to the seller’s escrow company when the seller accepts the contract. Such an amount will be held in an escrow account until the closing and after the title is delivered to the homebuyer. If something goes wrong with the transaction (like the home inspection reveals severe flaws), then the earnest money should be returned to you unless it was nonrefundable (which can happen in a competitive buying market). The amount of the earnest money can be negotiated. At closing, that earnest money goes toward your down payment.
Once all parties have executed the terms of the contract, you must obtain a mortgage commitment from a financial institution (your bank) and hire a title company or attorney to perform a title search. A title search makes sure there are no claims on the property, and confirms that the seller has full ownership of the property they’re selling you.
After your bank gives you a mortgage commitment and you have worked out all of the title issues present on your title report, you will be ready to schedule the closing. Just prior to the scheduled closing date, though, it is important to walk through the house to ensure that all of the seller’s commitments have been fulfilled. You must bring a paid homeowners insurance policy, enough money to cover the down payment and closing costs, as well as photo identification to the closing.
The seller will prefer payment in the form of a cashier’s check or a certified check. These forms of payment are guaranteed by the bank or credit union on which the check is drawn. Once you receive an executed deed, you’ll get the keys to your new home!
Closing costs are all of the costs associated with the transfer of the property, the processing of your mortgage, and the fees charged by those who make it all happen. Closing costs include:
Closing costs vary by location but are typically 2 to 5 percent of your loan, so if you’re buying a $100,000 house, you can expect closing costs to be between $2,000 and $5,000. Like the down payment, closing costs must be paid at the time of purchase. Federal law requires lenders to provide you with a good faith estimate of your closing costs before you go to settlement.
An escrow account is a special account your lender sets up if your mortgage payments will include amounts for property taxes and homeowners insurance, and the lender or mortgage servicing company will be disbursing the money when these bills become due. If you have trouble saving for large expenses, escrow accounts can make it easier because each month you pay one-twelfth of the annual amounts needed. However, you’re paying the money before it’s really due and, in most cases, not earning any interest on it.
Lenders can easily make mistakes in escrow accounts, so it’s important to keep an eye on them and make sure that you’re not paying more than is necessary. By law, there has to be at least one month per year when the balance in your account is no more than one-sixth of your annual expenses paid from escrow. Once a year your lender will perform an escrow analysis to determine how much money should be deposited into the account for the coming year in order to cover the expenses that will be paid. If you have more than $50 in excess of what’s needed, you should receive a refund. If you have a shortage, one-twelfth of the amount needed may be added to your monthly payments for the next year.
When you own a home, you may be able to deduct the mortgage interest and a few related costs from your taxable income by itemizing your deductions on Schedule A with Form 1040. By the end of January each year, your lender will send you a Form 1098 showing the amount of mortgage interest you paid during that year. Points you paid at closing may be deductible the first year you own your home if they meet a number of IRS requirements. If your points don’t meet these requirements, you can deduct them over the life of the loan. For a complete list of the requirements and limitations on deductibility of home mortgage interest, see IRS Publication 936, Home Mortgage Interest Deduction.
You may also be able to deduct up to $10,000 of real estate property taxes from your taxable income. If property taxes are included in your mortgage payment and paid by your lender, claim the amount the lender actually paid out during the year, not the amounts included for taxes in your monthly mortgage payments. Your lender places these funds in an escrow account for safekeeping and uses the funds to pay your real estate and insurance. Frequently real estate taxes are adjusted at the closing so that the purchaser may have actually paid more or less than the real estate taxes paid to the government in the year of closing. Your attorney’s closing statement should disclose the amount of this adjustment and whether it should be added to, or deducted from, the amount paid to the government during the year in order to determine your real estate tax deduction.
If your local real estate taxes include charges for services such as trash removal or water and sewer, this portion of your taxes is not deductible. Look carefully at your copy of the real estate tax bill to determine how much you can deduct. The bill should identify services separately from taxes, which are based on the value of your property.
Mortgage payments aren’t the only expense to consider when evaluating whether you can afford to buy a house and how much you can afford to spend. There are also:
Utilities can be very expensive if you live in a region of the country with extreme temperatures, such as the Northeast, where bone-chilling winters drive up heating costs, or in the South, where hot, humid summers run up air conditioning bills.
If you’ve been renting and are considering buying a house, try to think of all the things you’ll need to buy that you didn’t need when you had a landlord. You may need a lawnmower, weed whacker, chipper/shredder, leaf blower, rototiller, or other lawn and garden equipment; a washer and dryer, a new stove or refrigerator, or other household appliances; a snowblower or snowplow. Then there are the items that aren’t absolutely necessary but that you’ll want to have as soon as possible, such as window coverings (blinds, shades, or curtains) and new or additional furniture. If you’re buying a fixer-upper, you’ll need money for materials even if you intend to do most of the work yourself.
Buy a less expensive house than you can afford. Then you’ll have money for other things and won’t be as likely to get in over your head with credit card and consumer debt. You’ll even be able to make extra principal payments on your mortgage to pay it down faster or larger retirement account contributions to build up your future nest egg.
Most people use all the cash they can scrape together for the down payment and closing costs, and then end up having to use credit to buy the things they need or want for the new house. If you plan ahead and know how much house you can really afford, you can avoid being house poor—unable to afford anything but the house payment.
Some people decide to own a condo instead of a single-family home. You can share some costs with others, and you don’t have to do as much of the work yourself. In exchange for these benefits, you have to pay homeowners association (HOA) dues or some similar fee. HOA dues pay for things like yard work, snow removal, and possibly even some utilities. With condo-style homes (which can be apartments or townhomes) you own your home but not the property it’s on, so your HOA fees include property insurance, but not for insurance on your specific unit or anything inside it.
When shopping for a condo, make sure you consider the HOA dues in your budget. You might talk about mortgage costs with a lender, but don’t forget that you’ll owe an extra $100 to $500 per month for HOA dues. Higher HOA dues may mean that you get more from the HOA, but not always. Work with your real estate agent to understand how the HOA works and if it’s going to be worth it.
When you purchase a cooperative apartment, you do not technically own real estate (including your home). Instead you own shares in a corporation that owns the entire property. You become a tenant in a designated apartment in the building by signing a proprietary lease with the corporation. The co-op board of directors makes sure that the offering plan and the by-laws of the co-op are enforced. Each tenant is charged a maintenance fee that pays for the ongoing maintenance of the building along with real estate taxes, insurance, and the mortgage on the building. Although you do not technically own the real estate, for tax purposes you are entitled to deduct any interest associated with a co-op loan taken to purchase the premises as if it were a real estate mortgage. Additionally, any part of the monthly maintenance attributable to the payment of real estate taxes on the building or mortgage interest on the co-op’s mortgage will flow to you. So you may be able to deduct those amounts as itemized deductions on your tax return. Usually, the managing agent of the co-op will issue a statement informing the shareholders as to the portion of the maintenance charge properly allocable to mortgage interest and real estate taxes. Before you purchase a co-op, it is important to analyze the financial statements of the co-op carefully in order to determine whether the current maintenance charge is sufficient to support the co-op’s ongoing carrying costs.