How much can you really afford?
One of the first steps in buying a home is determining how much you can afford to spend. You should not simply apply for a mortgage and assume you can spend the maximum amount that the bank offers. Banks may be willing to lend you far more than you actually should spend. Borrowing the maximum amount will leave you strapped for cash and wishing you'd bought more conservatively.
So, then, how do you determine how much house you can afford? There are a bunch of different guidelines and recommendations out there, but really, you need to consider four basic questions:
1. How does your debt compare to your income?
Most personal finance experts recommend that you spend no more than 36% of your monthly income on debt. Sit down and total all of your income, and then total all of your debt payments. (Include things like your credit card payments, student loan debt, and medical debt.)
Multiply your current monthly income by 0.36, then subtract your total monthly debt payments from that number. The result is the maximum amount you should be putting toward a mortgage each month. However, that number will continue to be honed and refined as you work your way through answering the other questions on this list. We'll call that number your "monthly max with tax."
2. How much are property taxes in the area?
When you make your payment to the mortgage holder, you also pay a certain amount that the lender holds in escrow to pay your property taxes.
Ask your real estate agent or lender for information on property taxes in the area where you're buying. They should be able to give you a rough estimate of the annual taxes on a home near your price range. Subtract this tax from your "monthly max with tax."
For instance, if your taxes will be $300 a month, you would want to subtract $300 from your monthly payment max to arrive at the true amount you can afford to pay, only towards the loan (not taxes) each month. We'll call this number your "monthly max."
3. How much of a down payment do you have?
The more you put down on a certain home, the less you will be borrowing, so the more home you can afford. For example, if you buy a $100,000 home with a $5,000 down payment, you will be borrowing $95,000, but if you buy the same home with a $20,000 down payment, you'll be borrowing $80,000. It's definitely to your advantage to save for a larger down payment, if possible.
4. What home price does your monthly max and down payment equate to?
Now that you have your monthly max and your down payment amount, the only other piece of information you'll need to calculate your ideal home price is the interest rate on your loan. Your bank will tell you what interest rate you qualify for when you apply for pre-qualification. Plug your monthly max, down payment, and mortgage rate into an online calculator, like this one, to see what home price you can afford.
Keep in mind that the result is still the maximum you should spend, and you should adjust it according to your own circumstances. For instance, if you calculate that you should spend no more than $200,000 when buying a home, but you know you have a lot of other expenses coming up, you may want to adjust it down and look for homes at $180,000 or less.
When buying a home, it is important not to over-buy. Walk through the questions above to figure out how much you can afford, and also remember that everyone is different; these are guidelines, not rules.