How much house can I afford?
The topic of house affordability comes up often, this topic should be taken very seriously as this will decide your economical fate in the next few years.
First thing you should do is to set a price before you even start looking for a property. That way you can narrow down your choices. But how do you do this? This few steps can help you navigate how much house can you afford.
The rule of thumb is buy a house that is no more than 2 x your gross annual income.
Before we get started I want to tell you; Live within your means.
It is of no use to buy a very expensive house that leaves you without cash reserves (savings) to repair the A/C WHEN it breaks down, because it will breakdown or when the plumbing gets clogged etc.
You could want a million dollar estate, but could you afford it?
Step 1 - Get pre approved for a mortgage
When you start looking at properties it is important to get pre approved for a mortgage. This way when you find a property that you like and fits your budget you can make an offer.
Important to make a distinction between pre qualified and pre approved. Pre qualified is just based on data you submitted to a bank not yet verified, gives you a glimpse of how big a loan you can actually get.
To get pre approved means your data was verified by the bank and they granted you an agreement letter to loan the money. They will analyze;
-Debt to income ratio
-Assets and liabilities
The pre approval letters from banks typically last for 60-90 days. It will give you a solid idea of how big a mortgage you can get according to your finances. It will make you a more attractive buyer when you are in the market for a property.
What is Debt to Income ratio and why you should know?
You should know what your DTI because this metric will be used by banks to determine how much money they will lend you.
DTI is a comparison of Total Monthly Debts (mortgage/rent, student loan payment, car payment etc) to Pre-tax income.
Typically banks use 36% as the optimal number to lend you money.
You can calculate easily this by multiplying your pre-tax income by .36.
Your gross monthly pre-tax income x 0.36 = Target monthly mortgage payment.
For example $5000.00 monthly pre-tax income x 0.36 = $1,800.00 should be the target monthly mortgage payments you could afford.
36% is safe number, you could go higher understanding you could be stretching yourself thin and leaving little room to maneuver should the unexpected happen. However this number is decided by the bank, they usually set minimum requirements.
One way to alter these numbers is by keeping debt down to a minimum.
Credit score -
Keep in mind credit score also plays an important role, usually banks require scores of more than 680 to qualify for a good mortgage interest rate.
Why is it important to have a good credit score?
Let's take a closer look;
Joe has a poor credit score of ~450, gets a 4% interest rate on a 30 year fixed mortgage; this means for a typical $200k property with a 20% down payment he will be paying $955.00 a month (not counting insurance/taxes etc.).
Jim has an excellent credit score of ~780, gets a 2.8% interest rate on a 30 year fixed mortgage; this means for a typical $200k property with a 20% down payment he will be paying $822.00 a month (not counting insurance/taxes etc.).
Jim pays $133.00 less per month, $1,596.00 less per year just because he has a good credit history.
Did I get your attention on why the credit score is important???
Step 2 - Determine what will your monthly payment be.
Your monthly payment will not only be the mortgage, there is a little more to it.
You will have to factor in 2 important details when buying a house-
-Taxes - Taxes will be payed yearly, they will depend on which state you live, Miami-dade county tax ix ~1% of the property value (this will be determined by the state appraisal not by you). The more expensive the property the more taxes you will pay.
-Homeowners insurance - Bank will require you insurance to secure their investment, therefore they will require you to have homeowners insurance. Your insurance broker can give you a glimpse of how much you will be spending. The more expensive the house, waterfront and if it is in a flood zone are all factors that come into play, talk to your insurance broker.
-HOA's - (Home Owners Association fees) find out if there are any, typically a gated community or a condo WILL have one, factor this into the monthly payment.
The above information could be found easily in the internet nowadays, state websites will have this info, you just have to dig a little.
Step 3 - Property hunt !!
Knowing how much you can afford, now you can start looking at properties and narrow a price point with your realtor. Please do yourself a favor and get a realtor. They will get properties for you to look at, schedule showings and negotiate a price. Websites with real estate information may not have the most up to date information, also your real estate broker may know a particular neighborhood and know properties which may be coming into the market but not yet listed.
Do not let yourself get paralysis by analysis, where you are just browsing zillow, take action.
Final word of advice -
If you are serious enough to be looking at properties, my serious advice is to do your due diligence and complete steps 1-2. Steps 1-2 are the most basic yet most instrumental steps when buying a property since they will give you a concrete idea as to how much you can spend on a property.
Let's say you found your dream property, at the price you want (and can pay), but you are not prepared, so you cannot offer any money for the property. When you come back ready to purchase the property, it may be sold (yes it happens that fast).
Till next time.
Disclaimer - This blog is meant purely for educational discussion of finance. It contains only general information about financial matters. It is not financial advice, should not be treated as such.