How Much House Is Affordable?

Apr 18, 2014 by

homeA special treat today: a guest post by Tali Wee of residential real estate titan Zillow. Enjoy!

Home shoppers beginning their searches often struggle with where to start the process. Before addressing the important home qualifiers such as location, number of bedrooms and a master list of must-have features, shoppers should carefully evaluate how much home they can afford. Once buyers settle on their maximum spends, they can really begin qualifying neighborhoods and property specifics.

As buyers shop for homes they can calculate housing expenses to get an idea of how much each mortgage might cost monthly. The general rule for affordability is a buyer’s mortgage, taxes and insurance combined should not exceed 25 to 28 percent of his or her monthly income. However, buyers should assess a handful of other factors to determine how much they truly can afford. Here are five additional components for buyers to calculate.

1. Disposable Income

First-time buyers who currently rent are accustomed to their monthly rents and lifestyles. Typically, rents are less than mortgages, and almost always less than the total costs of homeownership. In homes, utility bills increase due to the size of the property and all maintenance becomes the homeowner’s responsibility. Therefore, first-time buyers have to alter their spending habits to meet their new bills. Evaluate budgets to identify the best places to cut corners. If buyers aren’t willing to give up nights out or other expenses, they should only search for homes costing close to or less than their current rents.

2. Debt-to-Income Ratio

Another guideline to help identify how much buyers can afford is their debt-to-income ratio (DTI). To calculate DTI, add up the cost of housing expenses (monthly mortgages, taxes, insurance) plus all other monthly obligations such as minimum credit card payments, student loan payments, car payments, etc. Buyers should then divide that sum by their gross monthly incomes. The resulting percentage is the buyers DTI and should not exceed 43 percent of his or her monthly income. As a general rule, conventional loan buyers need a DTI of 36 percent and FHA loan buyers, 41 percent. Buyers with higher DTIs should work to reduce debt before buying a home.

3. Credit Score

A buyer’s credit score is a major factor that dictates the mortgage interest rate offered by the lender. Higher interest rates make borrowing money from the lender more expensive, and therefore create higher monthly mortgage payments. Buyers with interest rates of 740 or above are offered the lowest interest rates available. If buyers have low credit scores, they should work on raising them before buying a home. Otherwise their loans will cost more and they’ll be able to afford less.

4. Down Payment & Closing Costs

Down payments range between 5 and 20 percent of the total value of the home. Homebuyers who want to avoid paying private mortgage insurance (PMI) should be prepared to pay the full 20 percent of the price of the home as their down payments. PMI is insurance paid to the lender to protect the lender’s investment; it’s paid by the borrower until he or she has 20 percent equity in the home. In addition to the down payment, buyers pay closing costs of 2 to 5 percent of the home’s purchase price. It is negotiable for the seller to cover a portion of the closing costs, but first-time buyers calculating affordability should factor in potential closing costs.

5. Maintenance Costs

Buyers can assume annual maintenance costs of 1 to 4 percent of the total price of their homes. Each year homeowners have to pay for upkeep on their properties from big ticket items such as replacing the roof, windows, water damage or HVAC system to smaller repairs including adding attic insulation, painting, replacing a screen, light bulbs or filter. All of these basic maintenance costs add up quickly and they’re entirely new costs for first-time buyers who are accustomed to their landlords paying for maintenance.

Though affordability is entirely circumstantial, prospective buyers can use these guidelines to evaluate their budgets, calculate their DTI and potential interest rates while accounting for closing costs and future home repairs. When all of these steps are balanced and compared to the expert recommended percentages, buyers have a great baseline to begin home shopping.

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