You’ve rented for years and are yearning to buy a home of your own. But how do you know what your house-hunting budget should be?
Good news: With just a little financial information you can actually do those affordability calculations before you officially begin shopping for a mortgage. Here are the top things lenders typically consider when determining how much house you can afford.
One of the first factors a lender will analyze is your debt-to-income ratio, or DTI. Lenders use this measurement to ensure that you’ll have enough income to cover both your new mortgage payment and any existing monthly debts such as credit card, auto loan and student loan payments.
Generally most lenders want your debt-to-income ratio, including your anticipated new monthly mortgage payment, not to exceed 36 percent. The ratio is calculated by taking your total monthly debt load and dividing it by your monthly gross income.
What does that mean in dollars and cents? Someone who earns $5,000 per month and carries $500 in monthly debt would have a DTI of 10 percent. This borrower generally could be approved for a maximum monthly mortgage payment of $1,300, including property taxes, homeowners insurance and private mortgage insurance. Someone making the same salary but carrying zero debt generally could be approved for a maximum monthly mortgage payment of $1,800.
There are several key factors in securing a mortgage loan, and your credit is one of the most important elements. Your credit scores is based on your payment history, overall level of debt, length of credit history, types of credit and applications for new credit.
If your credit score falls within an undesirable range or includes unfavorable marks, traditional lenders might be leery of approving you for a loan. You may be able to obtain a loan, but you’ll likely pay a higher mortgage rate, which will ultimately result in a higher mortgage payment.
Well before you apply for a home mortgage loan, pull your credit report to review where you stand, and research the requirements you need to meet with your desired lender. Understanding your personal credit profile and the lender’s expectations will help you understand the interest rates you likely qualify for and the terms your loan will likely be.
Down payment requirements
With the exception of Veterans Affairs (VA) loans and some special programs for first-time buyers, a home purchase requires that you have some cash on hand. How much? Anywhere from 3.5 percent of the sales price for a Federal Housing Administration (FHA) loan to as much as 20 percent for a conventional loan. Expect to get a better interest rate if you’re able to make a down payment of at least 20 percent.
Keep in mind that the down payment amount doesn’t include closing costs, which are fees related to the purchase of the home. Typically, buyers pay between 2 percent and 5 percent of the purchase price of the home in closing costs.
The big picture
If you have less-than-amazing credit, then you may want to consider waiting to purchase a home and making changes in your spending habits to improve your credit score. Many experts suggest before you even consider buying a home, you should be debt-free and have three to six months of expenses saved — in addition to your down payment and closing costs.
“Being debt-free or close to it with some money in the bank is optimal,” said Tiffany Kjellander, owner and operations manager of Augusta, NJ-based EXIT Towne & Country Realty. “It can be tough to hear that it’s not the right time for you to look for a house, but the truth is that getting your financials in order and putting some money in the bank could keep you from losing your home if you get sick or lose your job down the road.”
Further, Kjellander advises that potential homeowners think long term. The cost of homeownership extends beyond the monthly payment and includes routine maintenance and repairs, homeowners association dues and additional utilities that you might not have paid while renting.
“Just because you’re approved to spend $3,000 per month on a house doesn’t mean you have to go that high,” she said. “Buying a home is a huge financial decision. No one should enter into it blindly.”