HOW MUCH HOUSE
CAN YOU AFFORD?
There is a rule of thumb that says that if you have the capacity to repay the mortgage,
you can afford a single-family house that costs up to two and one-half times your annual
gross income. (Annual gross income is the amount you make before taxes are deducted.) Like
other rules of thumb, this one is handy and can give you a general idea of how large a
mortgage you can afford. But, because it is so simple, it doesn't take into account
all the information that will help you feel comfortable with your mortgage payments.
If you are buying a house with someone else (spouse,
parent, adult child, partner/companion, brother or sister or other relative), you should
consider your co-purchaser's earnings and existing debts as well. Remember, if you apply
for a loan with somebody else, you and your co-borrower are both legally responsible for
repayment of the mortgage.
Your buying power depends on how much you have
available for the down payment and how much a financial institution will agree to lend
you. Use our mortgage
calculator to figure your payments.
Your Down Payment
If you are a first-time home buyer, the price you
can afford to pay for a house may well be limited by your ability to come up with the
required down payment and closing costs. If you haven't accumulated much savings, you may
want to set aside funds for a down payment on a regular basis from your paycheck.
Monies in your checking and savings accounts, mutual funds, stocks and bonds, the cash
value of your life insurance policy, and gifts from parents or other relatives may all be
suitable sources for a down payment.
Saving enough money for the down payment is usually
the hardest part of getting ready to buy a home, especially if you're a first-time buyer.
It often takes many years. Most first-time buyers must carefully budget their
spending to save enough for the required down payment.
Depending on the lender and loan type, you may be
able to get a mortgage with as little as 3 percent or 5 percent down. However,
putting less than 20 percent down often means you will be required to purchase private
mortgage insurance. Private mortgage insurance helps protect the lending
institution in case you fail to make payments on your mortgage. Typically, costs
will be added to your monthly mortgage payments and to your closing costs.
In helping you decide how much money you feel
comfortable applying to your down payment, you should consider moving expenses, home
decorating costs, and any needed upcoming "big ticket" items (such a replacing a
car). You don't want to move into your new home with all your savings depleted.
In many cases, your lender will want you to have two
months of mortgage payments saved up as a cash reserve when you apply for your mortgage.
Your Closing Costs
In addition to the down payment, you will also need
to consider closing costs. The closing (or, in some parts of the country, settlement) is
the final step during which ownership of the house is transferred to you. The purpose of
the closing is to make sure the property is ready and able to be transferred from the
seller to you.
Closing costs generally range from 3 percent to 6
percent of the amount of the mortgage. So, if you were to buy a $100,000 house with a 5
percent ($5,000) down payment, you could expect to pay between $2,850 and $5,700 on your
$95,000 mortgage. Sometimes, you can negotiate with the seller of a property to pay some
of your closing costs, which will reduce the amount of money you will need to bring to
How Much a Financial Institution Will Lend
Apart from having available funds for a down payment
and closing costs, the other major factor limiting how expensive a house you can buy will
be how much you can borrow. When you apply for a mortgage, the lender will consider both
your earnings and your existing debts in determining the size of your loan.
Lenders generally use the following two qualifying
guidelines to determine what size mortgage you are eligible for:
- Your monthly expenses (including mortgage payments,
property taxes, insurance, and condominium or co-op fee, if applicable) should total no
more than 28 percent of your monthly gross (before-tax) income. This is called the housing
- Your monthly housing expenses plus other long-term
debts should total no more than 36 percent of your monthly gross income. This is called
the total debt-to-income ratio.
Basically, lenders are saying that a household
should spend no more than about one-fourth of its income (28 percent) on housing and no
more than about one-third of its income (36 percent) on total indebtedness (housing plus
other debts). Lenders feel that if they follow these guidelines, homeowners will be able
to pay off their mortgages fairly comfortably.
These lender ratios are flexible guidelines. If you
have a consistent record of paying rent that is very close in amount to your proposed
monthly mortgage payments or you make a large down payment, you may be able to use
somewhat higher ratios. Some lenders offer special loans for low- and moderate-income home
buyers that allow them to use as much as 33 percent of their gross monthly income for
housing expenses and 38 percent for total debt. One of these mortgage programs is Fannie
Mae's Community Home Buyer's ProgramSM.
When you go to apply for a mortgage, the lender will
use all the relevant data -- your income, your existing debts, the purchase price of the
house, your down payment, the interest rate on the loan, and the cost of property taxes
and insurance -- and calculate whether you qualify to borrow the amount of money you need
to buy the house.