Assess your financial situation
Before you even start looking for houses in your area, take inventory of your present finances. What is your monthly income? What are your monthly expenses? These sorts of questions will help you understand how a monthly mortgage payment payment might fit into your existing household budget.
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Evaluate your income
Start by evaluating your monthly income. Simply add up the annual income and divide by 12. If you’re self-employed or a freelancer, you can use the net income from your most recent tax return as your annual income, then divide by 12.
Tip: gather any pay stubs and tax records now, which will save you time when you’re ready to apply for a loan.
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Create a household budget
Do you use a household budget? If not, it’s time to create one. Most financial experts recommend using the 50/30/20 rule:
- 50% of your budget goes to “needs” (groceries, bills, etc.)
- 30% of your budget goes to “wants” (entertainment, meals out, etc.)
- 20% of your budget goes to savings and investments
Your monthly mortgage payments will fall into the “needs” category. So make sure that your current budget has enough room to allow for an extra payment of $1,500 to $2,000 each month.
Calculate your debt-to-income ratio
When you apply for a home loan, lenders will look at your debt-to-income ratio. This is the relationship between how much you earn each month and your total monthly debts. For example, if you bring in $7,500 each month but spend $2,000 on car payments or student loans, your debt-to-income ratio is 27%.
Most lenders will tell you that a “good” debt-to-income ratio is below 43%, though 35% or lower would be ideal. If you’re struggling with high debt, it may be wise to try to pay off that car loan or credit card bill before shopping for a house.
Home affordability calculator
It’s easy for all of these financial factors to make your head spin. If you want a quick snapshot of how much house you can afford, just use a free home affordability calculator. You’ll get answers to top questions about home price and the amount of your monthly payments, so start today to get a clearer picture of what you can afford.
The 28/36 rule
Some real estate experts recommend the 28/36 rule of home affordability. According to this rule, you should spend no more than 28% of your gross monthly income on housing costs and no more than 36% on all your debt combined.
This is just a guideline, of course, but can help determine the home price you might be aiming for. Again, if your monthly debts exceed these guidelines, you may want to consider paying down debt before shopping for a home.
Mortgage factors to consider
While you should start by evaluating your finances, it’s also important to consider various mortgage factors and how they relate to home affordability.
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First, it’s important to understand that different types of mortgage loans bring different costs. Typically, the most affordable mortgage program is a conventional loan.
These loan programs offer low mortgage interest rates<2.2 mortgage interest rates> and flexible loan terms. However, they still require at least a 3% down payment, and lenders reserve the best loan options for those with good credit.
If your credit score is on the low side, you might consider a loan backed by the Federal Housing Administration (FHA). FHA loans are available for those with a credit score as low as 500, though this will require a down payment of at least 10%. With scores above 580, you’ll still need a down payment of 3.5%.
Other loan programs (such as VA loans or USDA loans don’t require any down payment, but you’ll have to meet additional qualifications for these loan types.
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Your exact monthly payment will largely depend on your loan term. The longer your loan term, the lower your monthly payment — though a longer term will mean that you spend more over the years in interest payments. Some lenders also have prepayment penalties, which means you can’t pay off your loan early without paying an additional cost.
For example, a 15-year mortgage term will reduce the interest you’ll pay over the lifespan of your mortgage. But on the flip side, a 30-year mortgage will allow you to spread out your monthly mortgage payments over many years, which reduces the amount you’ll owe each month. For many homeowners, this is the wiser choice, since it will make it easier to fit your mortgage payments into your monthly budget.
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Your monthly mortgage payments will also reflect your mortgage interest rate. That’s because each mortgage payment will include both the principal of the loan and the interest that you accrue over the life of the loan.
Even a slight difference in interest rates can significantly impact over time. Lenders determine interest rates based on your financial situation and credit history. Always check your credit report for any blemishes that might be artificially lowering your credit, and work to build your credit score as much as possible to secure the best interest rates.
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Your down payment is your largest upfront cost. Traditionally, homebuyers have made a 20% down payment and then used the mortgage to cover the remainder of the cost of the home. But not every loan program requires a down payment. VA loans and USDA loans don’t require a down payment, and even FHA loans can go as low as 3.5% for those with a credit score of 580 or better.
What about traditional loans? Depending on your lender, you may be able to purchase a home with a down payment as low as 3%. Just keep in mind that when you make a down payment of less than 20%, you’ll be responsible for something called private mortgage insurance (PMI) , which can be rolled into your monthly mortgage payment.
So a low down payment might put a house within easier reach, but you’ll have higher monthly payments for the duration of your loan.
Other factors to consider
There are many factors to consider when buying a home. It’s tempting to clear out your bank account to make a hefty down payment, but that’s not the best idea. Here are some other costs and factors to consider when you are preparing to buy a home.
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Closing Costs
When buying a home, you’ll be responsible for a small collection of fees known as “closing costs.” These are the administrative and legal fees that are required to purchase the home and create a mortgage contract.
How much are closing costs? Typically, these fees can be anywhere from 3% to 6% of your total loan amount — but that can add up. For instance, if you purchase a home for $400,000 and make a down payment of $80,000, you could be looking at closing costs of $10,000 or more. Many lenders expect these costs upfront, so make sure to have cash on hand to cover these fees.
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Emergency funds
Do you have a plan in place for unexpected expenses? Most financial experts recommend that you keep a separate emergency fund for things like car repairs or unforeseen medical bills.
Aim to save three to six months’ worth of your monthly expenses. The goal is to have a sufficient amount of savings so you don’t have to worry about dipping into your regular savings account or sinking into credit card debt to cover emergency costs.
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Housing expenses
As a homeowner, you’ll be responsible for a small list of housing expenses. This includes property tax, homeowners insurance, HOA fees, and more. Additionally, if you save money by purchasing an older home, you may need some funds to update the property or make other improvements.
If this is your first house, you may also need money for appliances or landscaping equipment. Take an inventory of what you need for a single-family home, and then work to have enough savings to purchase anything you might need to make the house truly yours.
Final thoughts
Buying a house can be an exciting experience! But homebuyers must consider every factor to ensure that they get the house they want at a price that fits their budget. These tips are a great way to evaluate your finances as well as know what to look for when shopping for a house or mortgage program.
Of course, it also helps to have the right lender. Always aim to compare the rates and terms of at least three different lenders so you can make sure you’re getting the best deal. And the right lender can also provide valuable guidance as you navigate an evolving real estate market. Exploring home affordability can ensure that the right home is within your reach.
