How Much House Can You Afford

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Resource
There are several books that explain the ins and outs of buying or
selling a home yourself, including Nolo’s Essential Guide to Buying Your First
Home, by Ilona Bray, Alayna Schroeder, and Marcia Stewart (Nolo). For California
residents, there’s also How to Buy a House in California, by Ralph Warner, Ira
Serkes, and George Devine, and For Sale by Owner in California, by George Devine
(both by Nolo).
How Much House Can You Afford?
Notwithstanding the recent drop in home values, many prospective
homebuyers face an affordability problem when it comes to buying the
house they’d really like to live in, even when interest rates are at a fairly
low level. In that type of market, it’s essential to determine how much you
can afford to pay before you start looking. Many people don’t understand
how institutional lenders (banks, savings and loans, and credit unions)
determine how much money they’ll lend to you. If you don’t do the
calculations or talk to a loan broker ahead of time, you may enter into a
home purchase contract and then not qualify for the necessary loan.
As part of this initial evaluation, you must also decide whether both of
you or just one of you will own the property. Deciding to buy jointly is
primarily a relationship issue, but knowing your financial limitations is
an important part of the discussion about how you will take title.
As a broad generalization, most people can afford to purchase a house
worth about three times their total (gross) annual income, assuming a
20% down payment and a moderate amount of other long-term debts.
With no other debts, most people can afford a house worth up to four
times their annual income.
A more specific way to determine how much house you can afford is
to compare your monthly carrying costs (monthly payments of mortgage
principal and interest, insurance, and property taxes) plus your monthly
payments on other long-term debts, to your gross (total) monthly income.
This is called the “debt-to-income ratio.” Lenders normally want you to
make all monthly payments with 28%–38% of your monthly income.
You can qualify near the bottom or the top of this range depending
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Your Credit Score Is Important When
Applying for a Home Loan
When deciding whether to approve your home loan application, most
lenders will consider your credit score. Credit scores are numerical
calculations that are supposed to indicate the risk that you will default on
your payments. High credit scores indicate less risk and low scores indicate
potential problems.
Factors that credit bureaus use when generating credit scores include:
• your payment history
• amounts you owe on credit accounts
• length of your credit history—in general, a longer credit history
increases the score
• your new credit. It helps to have an established credit history without
too many new accounts. Opening several accounts in a short period
of time can represent greater risk.
• types of credit—credit scorers look for a “healthy mix” of different
types of credit.
You can get your credit score from the nation’s biggest credit scoring
company, Fair, Isaac, and Company, for a fee of $12.95. Visit www.equifax.
com, www.myfico.com, or www.scorepower.com for a report. And if you
live in California, you’re in luck. A new California law requires that mortgage
lenders disclose a consumer’s credit scores when the consumer is shopping
for a mortgage.
If you do get your credit score and it seems lower than it should be, there
may be a mistake on your credit report. (See Chapter 3 for information on
how to get a free copy of your credit report and correct errors, if necessary.)
To keep up on credit scoring developments, visit www.creditscoring.com,
a private website devoted to credit scoring.
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on the amount of your down payment, the interest rate on the type
of mortgage you want, your credit history, the amount of your other
long-term debts, your employment stability and prospects, the lender’s
philosophy, and the money supply in the general economy. In some cities,
there are special subsidies to help first-time homebuyers, often with the
down payment or mortgage.
Generally, the greater your other debts, the lower the percentage of
your income lenders will assume you have available to spend each month
on housing. Conversely, if you have no long-term debts, a great credit
history, and will make a larger than normal down payment, a lender
may approve carrying costs that exceed 38% of your monthly income—
sometimes as high as 40% or 42%. In any case, these rules aren’t absolute.
And bear in mind that getting a loan isn’t as easy as it once was.
Prepare a Financial Statement
The first step in determining the purchase price you can afford is to prepare
a thorough list of your monthly income and your monthly expenses.
Total monthly gross income. List your combined gross monthly income
from all sources. Gross income is total income before withholdings are
deducted. Include income from:
• employment—your base salary or wages plus any bonuses, tips,
commissions, or overtime you regularly receive
• public benefits
• dividends from stocks, bonds, and similar investments
• freelance income, self-employment, and hobbies, and
• royalties and rents.
Total monthly deductions. Total up all required monthly deductions
from your income (such as taxes and Social Security deducted from
your paycheck). Don’t include money deducted to pay credit unions,
child support, or other debts. If you deliberately have more money than
necessary subtracted from federal or state income tax by underclaiming
deductions, ask your employer what amount you are obligated to pay.
Total monthly net income. Subtract your total monthly deductions from
your total monthly gross income to arrive at your net income.
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Total monthly expenses. List and total up what you spend each month
on the following:
• child care
• clothing
• current educational costs
• food—include eating at restaurants, as well as at home
• insurance—auto, life, medical, disability
• medical expenses not covered by insurance
• personal expenses—include costs for personal care (haircuts, shoe
repairs, and toiletries) and fun (attending movies and theater,
renting DVDs and videos, buying CDs, books, and lottery tickets,
subscribing to newspapers and magazines)
• installment payments—student loans, car payments, child support,
alimony, personal loans, credit cards, and any others
• taxes
• transportation
• utilities, and
• other—such as regular charitable or community donations and
savings deposits.
How Much Down Payment Will You Make?
Unless you’re eligible for a government-subsidized mortgage that has
a low (or even no) down payment, you’ll probably need to put down
5%–10% of the cost of the house to qualify for a loan. Also, you’ll have
to pay the closing costs, which will be an additional 2%–5% of the cost
of the home. Some banks still will make mortgage loans with less than
5% down, although the monthly interest rate may be higher than if you
put down more.
Generally speaking, the larger the percentage of the total price of a
house you can put down, the easier it will be for you to qualify for a
mortgage. This is because larger down payments mean less money due
each month to pay off your mortgage. The monthly mortgage payment
(plus taxes and insurance) is the major factor in determining the purchase
price of the house you can afford.
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Total up the money you have for a down payment and then multiply
this number first by five and then by ten. These figures represent the very
broad price range of house prices you can likely afford, based on your
ability to make a down payment. Of course, you must be able to afford
the monthly mortgage, interest, and property tax payments too. If your
income is relatively low, you’ll have to increase your down payment to
25%–30% or even more to bring down the monthly payments.
Estimate the Mortgage Interest Rate You’ll Likely Pay
Because different mortgage types carry different interest rates, start by
deciding the type of mortgage you want. For a reading of the market’s
direction, check the mortgage interest rate roundup published in the real
estate sections of many Sunday newspapers.
In general, adjustable rate mortgages (ARMs) have slightly lower
initial interest rates and payment requirements than do fixed rate loans,
and are therefore more affordable than fixed rate loans. This isn’t saying
they’re better, however. Before selecting an ARM, compare interest
rates by looking at the ARM’s annual percentage rate (APR), not just its
introductory rate. (APR is an estimate of the credit cost over the entire
life of the loan.)
Calculate How Much House You Can Afford
Now that you have a pretty good idea of the size of your down payment
and the interest rate you expect to pay, you can calculate how much house
you can afford.
Step 1. Estimate how much you think a house that has the features you
consider your highest priorities will cost.
Step 2. Estimate the likely mortgage interest rate you’ll end up paying.
If you’re eligible for a government-subsidized mortgage, be sure to use
those rates.
Step 3. Find your mortgage interest and principal payment factors per
$1,000 over the length of the loan (30 years is most common) on the
mortgate payment chart.
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Mortgage Principal and Interest Payment Factors (Per $1,000)
Interest
rate
15-year
mortgage
20-year
mortgage
25-year
mortgage
30-year
mortgage
2.00
6.44
5.06
4.24
3.70
2.25
6.55
5.18
4.36
3.82
2.50
6.67
5.30
4.49
3.95
2.75
6.79
5.42
4.61
4.08
3.00
6.91
5.55
4.74
4.22
3.25
7.03
5.67
4.87
4.35
3.50
7.15
5.80
5.01
4.49
3.75
7.27
5.93
5.14
4.63
4.00
7.40
6.06
5.28
4.77
4.25
7.52
6.19
5.42
4.92
4.50
7.65
6.33
5.56
5.07
4.75
7.78
6.46
5.70
5.22
5.00
7.91
6.60
5.85
5.37
5.25
8.04
6.74
5.99
5.52
5.50
8.17
6.88
6.14
5.68
5.75
8.30
7.02
6.29
5.84
6.00
8.44
7.16
6.44
6.00
6.25
8.57
7.31
6.60
6.16
6.50
8.71
7.46
6.75
6.32
6.75
8.85
7.60
6.91
6.49
7.00
8.99
7.75
7.07
6.65
7.25
9.13
7.90
7.23
6.82
7.50
9.27
8.06
7.39
6.99
7.75
9.41
8.21
7.55
7.16
8.00
9.56
8.36
7.72
7.34
8.25
9.70
8.52
7.88
7.51
8.50
9.85
8.68
8.05
7.69
8.75
9.99
8.84
8.22
7.87
9.00
10.14
9.00
8.39
8.05
9.25
10.29
9.16
8.56
8.23
9.50
10.44
9.32
8.74
8.41
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Step 4. Subtract the down payment you want to make from your
estimated purchase price. The result is the amount you’ll need to borrow.
Step 5. Multiply the factor from the mortgage principle and interest
chart by the number of thousands you’ll need to borrow. The result is
your monthly principal and interest payment.
Here’s an example of how to put the first five steps together.
Example: Bill and Mark estimate the house they want to buy will
cost $200,000. A 20% down payment of $40,000 leaves them with a
$160,000 mortgage loan. They plan to finance with an adjustable rate
mortgage (ARM), which they believe they can get at an interest rate
of 6%. The monthly factor per $1,000 for a 30-year loan at 6% rate is
6. So their monthly payments will begin at 160 x 6, or $960.
Step 6. To get the total carrying costs for the mortgage loan, add the
estimated monthly costs of homeowners’ insurance and property taxes.
Very roughly, homeowners’ insurance costs about $400 per $100,000 of
house value. On a $200,000 house, expect to pay $800 per year, or $67
per month.
Step 7. Property taxes are initially based on the new assessed value
(market price) of the house as of the date of transfer of title. They vary
from state to state and even county to county, so use 1% of the market
value as an estimated annual tax. (For an exact number, call the tax
assessor in the county in which you’re looking to buy.) On a $200,000
house, taxes would be about $2,000 per year, or $167 per month.
Step 8. Now total up your mortgage/interest payment, insurance, and
taxes. These are your monthly carrying costs.
Step 9. Total up the monthly payments on your long-term debts and
add this number to the monthly carrying costs you arrived at in Step 8.
Then, divide that total by a number between .28 and .38, depending on
your debt level (the fewer your debts, the higher number to divide by), to
determine the monthly income needed to qualify.
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If You Are Married or State Registered
The rules for buying and owning a home if you are legally married or state
registered in a jurisdiction that recognizes your relationship as “marriagelike” can be very different than the rules for unmarried buyers. The rules
differ during the purchasing and financing phase, the ownership phase, and
the “exit” phase. While the specific rules differ from state to state, and while
federal rules won’t apply to you, here’s a summary of what’s at stake for you
and what you need to pay attention to:
1. Purchase and Financing. In most states, a married couple is
considered a single economic unit. That means that you have one
credit rating, and you are evaluated as a unified borrower for loan
qualification purposes. If these same rules are applied to you, your
partner’s bad credit or bankruptcy could jeopardize your loan
approval—in ways that unmarried and unregistered couples don’t
encounter. While the rules are changing so quickly, it’s quite possible
that your mortgage broker or title officer won’t know about the new
rules, so your application may be mishandled at first.
2. Owning the House. Whether only one partner is an owner or you are
both legally on title, the rules about financial obligations may differ
dramatically if you are registered or married. You may be jointly liable
for each other’s debts, so one partner’s creditor may be able to put a
“lien” on the house even if it’s owned by the other partner. Allocating
the tax benefits under state tax law may be different than if you were
unregistered, though the IRS is not likely to honor your partnership
as a legal marriage. If you decide to refinance your house, your spouse
or partner may need to “sign off” the loan, even if the partner isn’t on
title. Remember, if you are married or registered you may be treated
as a single economic unit, with all these delightful consequences.
Being married or registered also changes the way you can take title. In
some states you can take title as community property or tenant by the
entireties, and the rights of survivorship (i.e., who gets the house if one
owner dies) may be different. If you have any questions about these rules,
you may need to check with an attorney, as your real estate agent may
not be aware of the new rules for your particular state.