So you’ve decided to buy a home. Congratulations! But before you embark on the sometimes exciting, sometimes nerve-racking process of looking for a house, it’s important to take a step back and evaluate how much you can comfortably afford.
“The two big mistakes that many first-time homebuyers often make are buying too much and buying too early,” says Adheesh Sharma, a director in Fidelity’s Strategic Advisers, Inc.
Taking the time to calculate how the cost of homeownership fits into your budget can help you avoid these pitfalls. Here are four factors to keep in mind as you consider what homeownership costs you’re willing and able to assume. Also, use our simple calculator: How much house can I afford.
|1.||Save for a significant down payment.|
In most cases, you’ll need to contribute a down payment of 20% of a home’s value in order to secure a mortgage. There are other options for buyers who haven’t saved enough, but these options are more expensive.
For example, if your down payment is less than 20% of the home’s value, you may end up paying a higher mortgage rate and be required to get private mortgage insurance (PMI). PMI generally costs from 0.5% to 1% of the total loan per year until your loan balance drops to 80% of what the home’s value was at the time of closing. The purchase price often serves as the appraised value, but you could have the house reappraised later and potentially eliminate PMI if you think that you may have achieved less than 80% of your home’s value. Appraisals, however, cost money too.
To hold costs down, keep saving until you can afford at least a standard 20% down payment. Use our calculator below to get a sense of how much you might afford to spend on a house, given your current income and savings.
|2.||Make sure your finances and credit are prepared.|
Many people start the home-buying process by submitting their financial information to a mortgage lender. The lender will evaluate factors including your savings, income, and credit score to preapprove you for a loan of a certain amount. So, make sure your credit score is as high as possible—that can help you get a better mortgage rate.
Also, beware of taking on too much debt. “Just because a bank tells you that you can borrow $300,000 doesn’t mean that you should,” cautions Sharma.
When lenders determine how much of a loan to offer you, they look at your debt-to-income ratio—that is, your monthly debt obligations divided by your monthly income. Generally, lenders like to keep that ratio between 36% and 42%. If you have no preexisting debt, a lender might approve a loan that amounts to 42% of your income.
But a large mortgage also means sizable monthly payments—which might make it hard to meet your other financial priorities. A good rule of thumb is to hold your housing costs to about 30% of your monthly income. The U.S. Department of Housing and Urban Development considers families who pay more to be “cost burdened”; such families may have difficulty covering other important expenses.
|3.||Make sure the mortgage fits your financial situation.|
Before you sign any loan paperwork, make sure you’re educated about the different kinds of loan options that are available to you, and which ones may make sense for your situation. Often, there are so many options involved that it’s like comparing apples to oranges. Different options will have different effects on your budget. Some will cost less in the short term and more over time, and some vice versa.
For instance, there are alternative loan programs, such as interest-only loans, which allow you to pay just the interest on the loan without paying down any principal. Or there are 80-10-10 loans, also known as piggyback loans, which essentially offer borrowers two loans bundled together to cover 90% of the home’s cost (while you contribute 10% as a down payment). These loans allow you to contribute a lower down payment and avoid PMI—but they’ll cost you more in the long run, because you’ll have a higher interest rate and a bigger monthly payment.
“Some people explore all sorts of options to afford a down payment, from 80-10-10 loans to taking loans from their families, to taking loans from their 401(k) plans,” says Sharma. “But all those options put a lot of pressure on your budget. Even though they might seem like a good deal at the time, they can end up being very stressful for many people.”
|4.||Think beyond the mortgage.|
Many homebuyers focus on the down payment and monthly mortgage costs when considering how much home they can afford, but being a homeowner entails other costs as well. At the time of purchase, you’ll be responsible for closing costs, which may amount to several thousand dollars. Also, take into account the costs of home insurance, property taxes, and any home ownership association fees or condo fees.
And then there are the costs of maintaining and improving your home. “New homeowners are often surprised by the unexpected costs that come up in the first few months,” says Sharma. “You want to make sure you have some savings set aside to take care of those expenses.”
Finally, don’t forget about your other priorities, such as saving for retirement and, if you have kids, their college education. If buying a house would put such a crunch on your budget that it would put these goals in jeopardy, you might consider continuing to rent for a while.
Once you’ve reviewed your savings, considered your budget, and factored in your other priorities, you’ll have a much better sense of how much house you can comfortably afford. That way you can feel confident about taking this significant step.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917