How Much House Can You Really Afford?
A Guide to Mortgages and Other Housing Payments
The decision to buy a new home is an exciting one. Calculating just how much you can afford in terms of a mortgage can be tricky, however, even for the most experienced homebuyers. These guidelines should make the process of buying a home a little less stressful.
Take All Housing Costs into Account
In order to accurately assess how much you can afford with regard to buying a home, you’ll need to understand how mortgages are structured. A typical mortgage is comprised of principal, interest, taxes and insurance.
- PRINCIPAL – THIS REFERS TO THE AMOUNT OF THE LOAN ITSELF, BEFORE ANY OTHER COSTS HAVE BEEN CONSIDERED. IF YOU HAVE A $150,000 MORTGAGE, THE PRINCIPAL OF THAT MORTGAGE IS $150,000.
- INTEREST – THIS IS THE AMOUNT OF MONEY THE LENDER KEEPS FROM THE HOMEOWNER’S MONTHLY PAYMENTS. YOU CAN HAVE EITHER A FIXED-RATE OR ADJUSTABLE-RATE MORTGAGE. IN A FIXED-RATE MORTGAGE, THE INTEREST RATE DOES NOT CHANGE OVER THE COURSE OF THE LOAN. THESE LOANS COMMONLY LAST 30 YEARS, BUT THERE ARE FIXED-RATE MORTGAGES AVAILABLE THAT DO NOT LAST AS LONG. IN AN ADJUSTABLE-RATE MORTGAGE, HOWEVER, THE INTEREST RATE CHANGES AFTER A CERTAIN PERIOD OF TIME. FOR EXAMPLE, IN A SEVEN-YEAR ADJUSTABLE-RATE MORTGAGE, THE HOMEOWNER WILL PAY A FIXED INTEREST RATE FOR SEVEN YEARS. AFTER THAT, THE INTEREST RATE WILL BE REEVALUATED AND CHANGED BASED ON MARKET CONDITIONS. ADJUSTABLE-RATE MORTGAGES ARE GREAT FOR HOMEOWNERS WHO DO NOT EXPECT TO STAY IN A HOME FOR A LONG TIME. COMMON TIMELINES FOR THIS TYPE OF LOAN INCLUDE THREE-YEAR, FIVE-YEAR AND SEVEN-YEAR TIMELINES.
- TAXES – HOMEOWNERS ARE REQUIRED TO PAY REAL ESTATE TAXES AND HAVE THE OPTION OF PAYING THESE ALL AT ONCE, OR THEY CAN PAY THESE TAXES AS PART OF THEIR MONTHLY MORTGAGE PAYMENT AND HAVE THE LENDER HOLD THEM IN ESCROW.
- INSURANCE – THERE ARE TWO TYPES OF HOMEOWNERS’ INSURANCE: PROPERTY INSURANCE AND PRIVATE MORTGAGE INSURANCE. PROPERTY INSURANCE PROTECTS THE HOME FROM FIRE, THEFT, SEVERE WEATHER AND OTHER UNFORESEEN CIRCUMSTANCES. PRIVATE MORTGAGE INSURANCE (PMI) PROTECTS THE LENDER IF THE BORROWER IS NOT ABLE TO PAY THE LOAN OFF. PRIVATE MORTGAGE INSURANCE IN MINIMIZED, AND, IN SOME CASES, NOT REQUIRED AT ALL FOR HOMEOWNERS WHO MAKE A DOWN PAYMENT OF AT LEAST 20%.
Evaluate Your Current Financial Situation
Your current financial situation can help you decide just how much house you can afford. Taking your front-end ratio, back-end ratio and credit score into account allows you to make the best decision on how much you can afford when it comes to a mortgage.
- FRONT-END RATIO – THIS IS THE PERCENTAGE OF YOUR GROSS INCOME THAT CAN BE DEDICATED TO MORTGAGE PAYMENTS EACH MONTH. YOU CAN CALCULATE YOUR FRONT-END RATIO BY DIVIDING YOUR TOTAL MONTHLY HOUSING EXPENSES BY YOUR GROSS MONTHLY INCOME.
- BACK-END RATIO – THIS REFERS TO HOW MUCH OF YOUR GROSS INCOME IS REQUIRED TO COVER YOUR DEBTS, INCLUDING: CREDIT CARD PAYMENTS, CAR PAYMENTS, CHILD SUPPORT OR STUDENT LOANS. YOU CAN CALCULATE YOUR BACK-END RATION BY DIVIDING YOUR TOTAL MONTHLY DEBT EXPENSES BY YOUR GROSS MONTHLY INCOME THEN MULTIPLYING BY 100.
- CREDIT SCORE – YOUR CREDIT SCORE ALSO PLAYS A ROLE IN HOW MUCH HOUSE YOU CAN AFFORD. BECAUSE A LOWER CREDIT SCORE INDICATES A CERTAIN AMOUNT OF RISK FOR THE LENDER, THE HOMEOWNER’S CREDIT SCORE AFFECTS THEIR ANNUAL PERCENTAGE RATE (APR). THE BETTER CREDIT A HOMEOWNER HAS, THE LESS THEY WILL BE REQUIRED TO PAY IN INTEREST AND THE MORE HOUSE THEY CAN AFFORD.
It’s important to take other costs of owning a home into account as well. While you may be able to afford the mortgage itself, other costs related to owning a home, such as maintenance, utilities or association fees, could stretch your budget.
General Rules of Thumb
There are a few different standard rules to think of when calculating how much you can afford in house payments.
- THE RULE OF 28 – YOUR MONTHLY MORTGAGE PAYMENT SHOULD NOT EXCEED 28% OF YOUR GROSS MONTHLY INCOME. THIS IS OFTEN CONSIDERED THE “GOLDEN RULE,” AND MANY LENDERS ABIDE BY IT.
- THE RULE OF 32 – YOUR TOTAL MONTHLY HOUSING PAYMENTS, INCLUDING ANY EXISTING MORTGAGE PAYMENTS, INSURANCE, TAXES, FEES AND UTILITIES, SHOULD NOT EXCEED 32% OF YOUR GROSS MONTHLY INCOME. THIS RULE TAKES INTO ACCOUNT MORE FACTORS THAN THE RULE OF 28.
- THE RULE OF 40 – YOUR TOTAL MONTHLY DEBT PAYMENTS, WHICH INCLUDE YOUR HOUSE PAYMENTS ALONG WITH CAR, CREDIT CARD OR OTHER LOAN PAYMENTS, SHOULD NOT EXCEED 40% OF YOUR GROSS MONTHLY INCOME. THIS RULE TAKES MOST OF YOUR MONTHLY FINANCIAL OBLIGATIONS INTO ACCOUNT.
- CONSERVATIVE ESTIMATES – IF YOU TEND TO BE FRUGAL, YOU MIGHT BE MORE COMFORTABLE CALCULATING HOW MUCH YOU CAN AFFORD IN A MORTGAGE FROM YOUR NET INCOME RATHER THAN YOUR GROSS INCOME. THIS WILL ALLOW YOU TO SAVE MORE MONEY IN THE LONG RUN.
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