How Much Can You Afford When Buying a House?
Understanding how much you can afford is probably the most important thing about home buying. Buying a home can be a complex process, but it doesn’t have to be hard Depending on your individual situation, your budget can affect everything from the neighborhoods where you look, to the size of the house, and even what type of financing you choose.
With a little preparation upfront, you can save a lot of time and hassle. Learn more about the documentation you need for the loan process and the costs involved. To speak to our recommended lender ( with no commitment) Click here
Loan prequalification vs. preapproval
One of the best ways to determine your budget is to have your real estate agent or lender prequalify you for a loan. Prequalification is different from preapproval because it is only an estimate of what you’ll be able to afford. On the other hand, preapproval is a more formal process where a lender examines your finances and agrees in advance to loan you money up to a specified amount.
What factors are important to lenders?
Banks and lending institutions will use several criteria to determine how much money they’ll agree to lend. These include:
- Your gross monthly income
- Your credit history
- The amount of your outstanding debts
- Your savings–or the amount of money you have available for a down payment and closing costs
- Your choice of mortgage (i.e. 30-year, FHA, etc.)
- Current interest rates
Two important ratios
Lenders also use your financial information to figure out two, very important ratios: the debt-to-income ratio and the housing expense ratio.
- Debt-to-income ratio
Many lenders use a rule of thumb that the amount of debt you are paying on each month (car payment, student loan, credit card, etc,) shouldn’t exceed more than 36 percent of your gross monthly income. FHA loans are slightly more lenient. To read more about financial ratios click here
- Housing expense ratio
It is generally difficult to obtain a loan if the mortgage payment will be more than 28 to 33 percent of your gross monthly income.
Down payments make a difference
If you can make a large down payment, lenders may be more lenient with their qualifying ratios. For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.
Other ways to improve your purchasing power
- Gifts If you’re having trouble saving money, many lenders will allow you to use gift funds for the down payment and closing costs. However, most lenders require a “gift letter” stating the gift doesn’t have to be repaid, and will also require you to pay at least a portion of the down payment with your own cash.
- Negotiating Closing costs through negotiation, some sellers may agree to pay all or most of your closing costs (for example, if you agree to meet their full asking price). If you choose to try this, make sure to ask your real estate agent for advice.
- Loan ProgramsMany local governments have special loan programs designed to help first-time homebuyers. Loans may be available at reduced interest rates, or with little or no down payments. Check with our preferred mortgage provider here
- Loan Types Some homebuyers choose Adjustable Rate Mortgages (ARMs) because of low initial interest rates. Others opt for 30-year fixed loans because they have lower monthly payments than 15-year loans. There are significant differences between different loans, so make sure to discuss the pros and cons of different loans with your agent or lender before making a decision.
Pros and cons of a 30-year fixed mortgage
The popular 30-year mortgage has a number of advantages, including:
- Lower monthly payment. Compared to a shorter term, such as 15 years, the 30-year mortgage offers lower, more affordable payments spread over time.
- Stability. With a 30-year mortgage, you lock in a consistent principal and interest payment. Because of the predictability, you can plan your housing expenses for the long term. Keep in mind: Your monthly housing payment can change if your homeowner’s insurance and property taxes go up or, less likely, down.
- Buying power. Because you have lower payments, you can qualify for a bigger loan and a more expensive house
- Flexibility. Lower monthly payments can free up some of your monthly budgets for other goals, like building an emergency fund, contributing to retirement or college tuition, or saving for home repairs and maintenance.
- Strategic use of debt. Some argue that Americans focus too much on paying down their mortgages rather than adding to their retirement accounts. A 30-year mortgage with a smaller monthly payment can allow you to save more for retirement
The 30-year mortgage also has some downsides:
- Higher total interest paid. Stretching out repayment to a 30-year term means you pay more overall in interest than you would with a shorter-term loan.
- Higher mortgage rates. Compared to 15-year loans, lenders charge higher interest rates for 30-year loans because they’re taking on the risk of not being repaid for a longer time span.
- Slower equity growth. The amortization table for a 30-year mortgage reveals a harsh reality: In the early years, almost all of your payments go to interest rather than principal. A 15-year loan brings a higher monthly payment but much faster payoff of the loan amount.
- Buying more house than you should. Just because you might be able to afford more house with a 30-year loan doesn’t mean you should stretch your budget to the breaking point. Give yourself some breathing room for other financial goals and unexpected expenses. Use Bankrate’s home affordability calculator to determine how much house you can afford.
Mortgage lock recommendations
A rate lock guarantees a lender will honor a specified interest rate at a specific cost for a set period. The benefit of a mortgage rate lock is that it protects you from market fluctuations. It also puts pressure on borrowers to make sure they close on homes before the rate-lock period expires. For example, if your lender locks in your rate at 3.75 percent for 45 days and rates jump up to 4 percent within that period, you’ll still get your loan at the lesser rate.
If they choose not to lock in your rate, you’ll have a “floating” rate. That’s not a bad strategy when interest rates are generally falling, but it could be costly in a rising rate environment. For risk-averse people who are looking for a mortgage, a rate-lock is a must. It’s a good idea to ask for a 45-day lock at a minimum; 60 days is even better.