“So, what’s your budget?”
This is one of the first questions you’ll be asked by a real estate agent when you begin your home search, and it’s an important one. It’s pretty important to know how much money you are willing and able to spend on your new home, since this decision will likely impact your finances for the next three decades.
But how do you even come up with a budget? Well, you can always guess… but we don’t recommend it, as you might end up in over your head. Let’s break down a few things about home-ownership, particularly how to pay for it. Saddle up!
The Down Payment
One of the most important aspects of determining your budget is figuring out how much you’ll be able to put down on the home. If you are able to put down $50,000 on that $200,000 house, then you will only need to borrow $150,000 from the bank. On the other hand, if you are only putting down $10,000 on that same $200,000 home, you will be borrowing $190,000. It may be trickier to find lenders willing to lend you the extra money, and you may also find that you will need to pay additional fees or a higher interest rate.
Types of Mortgages
In considering your available savings for a down payment, there are specific loan types to consider. There are two main types of mortgages: a conventional loan with a private lender or banking institution, or a government-backed loan.
Most government-backed mortgages come in one of three forms:
• FHA loans, insured by the Federal Housing Administration, were established to make home buying more affordable, especially for first-time buyers, by allowing down payments as low as 3.5% of the purchase price.
• VA loans are insured by the Department of Veterans Affairs and offer buyers low- or no down payment options and competitive mortgage rates. They’re available to current military service members and veterans only.
• USDA loans are backed by the U.S. Department of Agriculture and are geared toward rural property buyers who meet income requirements.
All three programs follow the limits for conforming loans and have low down payment requirements.
Conventional loans, on the other hand, are offered and backed by private entities such as banks, credit unions, private lenders or savings institutions. Borrowers need good credit to qualify. This is because the loans aren’t guaranteed by an outside source — so the possibility of borrower default poses a greater risk for lenders.
Conventional loans have terms of 10, 15, 20 or 30 years. They also require much larger down payments than government-backed loans. Borrowers are expected to put down at least 5%, but that amount can vary based on the lender and the borrower’s credit history.
If you can afford to save up a large down payment and build your credit score while lowering your debt-to-income ratio, a conventional loan is a great choice that can eliminate some of the extra fees and higher interest rates that may come with a government-backed loan.
The 28-36 Rule
An important metric that your bank uses to calculate the amount of mortgage you can borrow is the DTI ratio, or simply put, the ratio of your total monthly debts to your monthly pre-tax income. Most of the major mortgage lenders will use the 28-36 rule when determining how much money they are willing to lend you. The rule states that your total household expenses (mortgage, insurance, taxes, etc.) should not exceed 28 percent of your gross monthly income. Similarly, your total debt (student loans, car loans, etc.) should not exceed 36 percent of your monthly income. Though this rule is not set in stone and there are ways around it, this should give you a rough idea of how much money the banks will give you.
The final, and arguably most important, part of determining your budget is your lifestyle. Just because a bank will give you $500,000, doesn’t mean you need to spend that much. Perhaps you would prefer to obtain a smaller mortgage because you plan on retiring early, having more children, or switching to part-time work. Try to plan ahead over the next 30 years to decide what size mortgage will work for you.
The bottom line
Ultimately, the answer to the question of how much house you can afford will depend largely on the amount of money that a mortgage lender is willing to give you as well as your own plans for the future.
All of these options might seem overwhelming at first glance. But bear in mind that the type of loan you wind up getting will depend largely on your credit profile, income and overall financial goals. Before you start shopping for a home loan, take complete stock of your finances and try to boost your credit score as much as possible.