Most of us, at some point, dream of buying and owning a home. The pride of ownership and a sense of security are important motivating factors. In addition, the initial investment can grow into a significant profit because of property value appreciation.
For both first-time and experienced homebuyers, the question becomes: “How much home can I afford?”
Calculating the Limit
Before beginning a property search, prospective homebuyers must determine how much house they can afford. Working with a professional Realtor and lender at the outset will help identify “how much house” one can afford. In addition, it will save time, reduce stress, and eliminate disappointment.
Determining how much a prospective homebuyer can afford is a relatively straightforward calculation, and there are several internet tools to help. In addition, most lenders and your Realtor can help with the process.
Here are some simple steps to help determine a realistic home search that won’t overextend your budget:
Calculate Income
First, add up all the reliable, regular income sources and amounts. These should include regular salaries and wages, investment and dividend income, and other dependable ongoing income. Whatever the source, the income must be realistic, not short-term or “hoped-for” sources.
Total Ongoing Monthly Expenses
Monthly expenses should include all realistic household expenses, including food, utilities, insurance premiums, clothing, entertainment, medical insurance, transportation fuel and maintenance, gifts, and any other ongoing expenses. It is essential to be realistic. Estimates should be on the high side to help account for unforeseen future expenses.
To obtain an actual loan or preapproval, underwriters at banks and mortgage companies will require substantial income and expense documentation to approve a mortgage.
Brainstorming Prospective Home Purchase Prices
- Select a target home price.
- Calculate your down payment.
- Determine the mortgage principal (home price minus down payment).
- Check the prevailing mortgage interest rate.
- Set a mortgage duration.
Here is an example. Using a mortgage calculator, we assume a $350,000 home is within our price range, and we can make a 20% down payment ($70,000). We would have to finance $280,000 ($350,000 minus $70,000). The interest rate on the loan is a fixed 3.5% for 30 years (or 360 monthly payments).
The monthly mortgage principal and interest (P&I) payment amount for 360 months on this $280,000 mortgage will be $1,257.33.
RELATED: Home Affordability Calculator
Add Estimated Taxes and Homeowners Insurance
Next, research and estimate the monthly real estate taxes and homeowners insurance for similarly valued homes in the prospective home’s neighborhood.
For this example, we assume an additional $500 every month for taxes and insurance. While the total principal and interest remain constant for the life of the loan, taxes and insurance can increase each year.
After the down payment, the hypothetical total monthly loan payment for this $350,000 home would be $1,757.33, including principal, interest, taxes, and insurance (PITI). Be sure to include any area association fees (HOA or POA) in your estimates if required for the neighborhood.
Making the Determination
If the total monthly income is less than the estimated monthly expenses (including PITI), then a lower-priced home is the better option.
If the calculations show that income is substantially greater than the expenses, the homebuyer may be able to expand their search to include higher-priced homes.
Lenders’ Quick Affordability Calculator
One calculation lenders often use to award a mortgage preapproval is a simple formula known as the debt-to-income ratio or DTI.
To calculate the debt-to-income ratio, add up all your monthly debts and divide the total monthly income. The ratio should not exceed 40%. However, some lenders may approve borrowers at a higher DTI ratio in some instances.
Importance of Lender Preapproval
For peace of mind and to avoid disappointment in visiting properties for which the prospective buyer is not qualified, starting the home search process with a preapproval is essential. In fact, many Realtors require homebuyers to obtain preapproval before beginning the home search process.