Buyer's Guide - Step #2 - How Much Can I Afford?

Simply because you decided you might want to be a homeowner doesn't mean that its the right track quite yet.  Below, we'll talk about some dollars and cents and hopefully help you get an idea of how much you can afford.  After that, the fun starts - house hunting.  You might find that once you know your limits, there isn't anything appealing in your price range.  If you can only afford homes you doubt you'd be happy with, then remain a content renter and start saving with a purpose.  We definitely found that you can save a lot more money every month when you have a serious goal.

So on to some numbers...
You'll find some easy generalizations with a few simple searches, including: 6x your annual salary or 33% of monthly income after all debts is how much you can afford to pay on a mortgage.  You should hopefully have a good sense as to how much you are able to save on a monthly basis while renting, so you could also add that to your current rent to see how much you could afford to pay monthly.  Banks will look at your income and what you spend every month to service your debts.  They'll also look at your credit history to see if you've missed payments or perhaps have too many lines of credit open.

I would suggest visiting www.bankrate.com and playing around with their mortgage calculators to see how much of a mortgage you can afford based on your rough estimates of how much you can afford to spend on a home every month.  Keep in mind, there are going to be other charges in owning a home including taxes, home insurance, higher utility bills (compared to an apartment), and other regular maintenance items.  I've added an entire separate post on Financial Budgeting Tips.  It's a topic I could discuss all day and night, but let's not get too sidetracked.

The other big issue when it comes to affordability is how much you have to put towards your down payment.  0% down mortgages aren't likely to come back.  You can put down as little as 3.5% with an FHA mortgage and this is often a good option for first time home buyers (we purchased our home using an FHA mortgage an a lot less than 20% down).  Keep in mind that if you put less than 20% down, you'll have to pay for Private Mortgage Insurance (PMI), which helps assure the lender that they won't lose a lot of money if you quickly find you can't afford your home.  PMI is a monthly expense you'll have to pay until you reach 20% equity in your home, so you'll want to consider that in your budget.

From a seller's point of view, a bigger down payment shows a real commitment to the deal.  Imagine if you were selling a $500,000 home and you accept an offer from someone who is putting 1% down ($5,000) and financing the rest ($495,000).  You would be then risking the possibility that the buyer may not get approval for such a large loan, and with less money down, that buyer is more able to walk away if they find another house they are interested in.  A seller would often prefer to accept a lower offer from someone if they are more confident the deal will get done - don't forget, sellers are often moving themselves and the absolute last thing they want is to buy their new home and then find the sale of their old home has collapsed.

So, the bigger the down payment, the smaller the mortgage and the lower your monthly payments will be.  You'll also avoid PMI and your offer on a house will be viewed as more credible with a bigger down payment.  On the other hand, a small down payment may be all that you can afford, and sellers will likely understand that. 

I won't get into all the different types of mortgage options here - that's something you can do with your mortgage broker as you get going in your process - and we'll talk about mortgage brokers later.

With the next post, you are ready to move onto the fun part and get searching.