Mortgages have fine lines and details you need to understand before you sign a home loan. If you don’t know what the loan details include, you don’t know what your buying power is.
Your debt-to-income ratio, loan type, and down payment all come into effect. “So how much house can I afford?” is the perfect question, because it doesn’t neglect all the other aspects about buying your home.
Nobody has a quarter-million dollars laying around burning a hole in their pocket, and few buyers ever pay for a home in cash (not a smart financial decision, as it were).
We can’t know what your financial situation is, but we can tell you what you need to focus on to have the best possible chance of affording the home that you want.
- Existing Debt: Healthy debt is good. It establishes creditworthiness and tells financial institutions if you can be trusted or not. Healthy debt does not need to be terminated when you begin a home loan.
- PMI: Private mortgage insurance is often required by more lenders if you pay less than 20% for the down payment of your home. PMI increases the cost of your mortgage each month with less money going to the principle, so if it’s in your capability, a 20% down payment will avoid PMI and bring your debt-to-income ratio down.
- High Credit Score: Your credit history and credit score show lenders how trustworthy you are. With home loans being one of the biggest financial decisions anyone will make in their lifetime, your history and score will determine your eligibility to own a home.
This isn’t everything, but they are just a few examples of what you’ll need to factor in when determining what your home buying power truly is.
You do not want to sacrifice your lifestyle simply for the sake of becoming a homeowner. After all, you’ll be doing this for the next thirty years—you shouldn’t have to live a completely different lifestyle just to own a home.
However, your lifestyle may have something to do with your debt, and once you figure out where certain spending can be tied back, you can reduce your debt-to-income ratio to help your long-term finances and assist you in becoming a homeowner.
To buy a home, whether you’re a first time home buyer or not, you need to know about your debt-to-income ratio to ensure you’re making a wise decision.
What is a Debt-to-Income Ratio?
Debt is healthy when it’s used correctly. You need to build creditworthiness somehow, and managing debt responsibly can help. While it’s important, it shouldn’t be where the majority of your finances are being used.
Debt-to-income ratio refers to the percentage of your income that goes to debt. Simply put, if you make $1,000 and you owe $300 to debt, your debt-to-income ratio would be 30%.
You want to have healthy debt, but you don’t want it to ever put you in jeopardy of total bankruptcy in a short amount of time if your income changes.
Your debt-to-income ratio is important for your own personal financial freedom, but it also comes into play when you apply for a home loan. Too high a ratio, and you will be denied a loan for your home.
What Should My Down Payment Be?
Down payments should be a least 10% of the home’s total appraised value, not including what you expect to pay for closing costs.
10% can be a huge sum of money depending on your income and what type of home you’re looking for. Saving that 10% shouldn’t take more than a total of 36 months.
If it does, you’re not earning money fast enough to match what your mortgage would be anyway.
How Much Cash Should I Have Before Buying a House?
Your cash reserve is used as a security against income loss, and as a savings to ensure you don’t foreclose on your home at the same time. If you don’t currently have a cash reserve, you need to plan for it alongside your down payment.
Cash reserves, or emergency funds as some call them, should ideally reflect six months worth of expenses in the event of job loss, injury, or financial hardships.
This can be difficult to accurately predict for a lot of people and even harder to attain, but equally as important as having a down payment.
Buying a home is absolutely one of the biggest financial decisions you will ever make. You do not want to enter a home loan agreement with a high debt-to-income ratio solely because you really, really want to own a home.
Keep your debt-to-income ratio lower than 28% if possible, although going up to 36% isn’t an end-all, be-all. Down payments should be reflective of your efforts to continually support that home loan.
Don’t give away every single bit of your savings for that 10% down payment, because many of us are one bad week away from being unemployed in the current job climate, and we don’t need the stress of potential foreclosure weighing down on us on top of everything else.
A home loan shouldn’t financially sink you. Understand your income, your debt-to-income ratio, and what you can afford before you ever sign a home loan agreement.
Housing Costs FAQ's
Take 28% of your annual income (pre-tax), and that’s your mortgage budget. Typically, first time home buyers will make the mistake of having 70% of their income go to mortgage costs (or more, which is scary for financial security).The dream of owning a house often overshadows financial responsibility during the decision-making process, but when you hear that it’s likely the biggest financial decision that you’ll make in your lifetime, that’s true.
Homeownership is out of reach for many minimum wage workers. It’s a sad fact, but it’s true. Even if you’re able to make $15.00 per hour, you’re still underneath what would normally be considered the most low-bar income rating to qualify for a home.
Aside from qualifying for a loan, the debt-to-income ratio would be too great to afford a house.
Exceptions would be stationary mobile homes, rural area homes, fixer-uppers, and inconveniently-located areas with exceptionally low housing prices. Physical job locations around these areas tend to be reflective of the local housing market as well.
With a 10% down payment (the average minimum) of $55,600, on a 30-year fixed mortgage, you should be able to bring in over $8,000 per month to cover costs and not sacrifice quality of life with a high debt-to-income ratio.
This also offers financial security to prevent the homeowner from foreclosing and/or enduring financial hardships when life happens by allowing you to have room for a savings/emergency fund.
There’s no perfect debt-to-income ratio, but the 36% rule is often regarded as the gold standard. If you’re within a few percentage points of 36% but you’re not quite as low as the 28% that we talked about earlier, that’s okay.
Discuss your financial plan and future, and determine if 36% if doable for a home loan based on your current needs and limitations.
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