The idea of buying your first home can be as overwhelming as it is exciting. While you will have many decisions to make throughout the process, your first and most important consideration is what you can afford to spend on a house. You will need to consider several factors before making that determination.
Here are key questions to ask before embarking on your home buying journey:
How Much of a Monthly Payment Can I Afford?
The rule of thumb for your monthly mortgage payment is that it shouldn’t exceed 25 to 30 percent of your monthly gross income. In the mortgage lending world, this is called the “front end ratio,” and is calculated by adding your mortgage principal and interest, real estate taxes, mortgage insurance, and homeowners’ insurance and dividing it by your monthly gross income. Most lenders are looking at a number that won’t be higher than 28% of your income. If you wonder, “How much should your income be to buy a house?” try using a house payment affordability calculator.
Some other useful percentages to consider is that your total housing costs shouldn’t consume more than 32 percent of your gross monthly income. When renting, it is easy to underestimate the ongoing costs involved in homeownership, which range from simple and fairly inexpensive matters like an occasional call to a plumber for a leaking dishwasher to the unexpected and budget-busting costs of putting on a new roof.
There are also expenses rarely considered outside of repairs, like the cost of a new fence, landscaping upgrades, or remodeling a bathroom. While these expenditures are often not considered when applying for a loan, neglecting a budget for these expenses can be financially painful. Saving an additional 4-5% a month of your income for these repairs and upgrades and calculating that into your overall housing budget will give you the savings needed to complete future projects.
Keep in mind that your total household debt should not exceed 40% of your gross monthly income. Lenders will look at debts which will include car loans, monthly credit card payments, student loans, alimony or child support. However, if you have other fixed monthly expenses that aren’t considered debt but you feel obligated to pay, you will want to include these as well; some examples include, church tithes and charity donations, private school tuition, gym memberships etc. Considering all fixed monthly obligations when determining your loan amount and monthly mortgage payment will keep you on track for a healthy financial future.
What Savings Are Needed for a Down Payment?
There are several factors when determining how much is needed for a down payment, but let’s look at the two most important: What does the lender require, and what should I put toward a down payment? Knowing the answers to these questions can help you determine what type of loan works best for your situation, and what savings will be needed.
20% Down Payment
Typically putting down a 20% down payment (20% of the value of the home) is the industry standard. This allows the lender to see your seriousness of home ownership, makes negotiating for the best interest rate possible, and keeps you free of PMI (private mortgage insurance). Saving for months or even years for a down payment not only shows your lender your financial prudence, it also proves to yourself that you are ready for this anticipated milestone.
Good credit combined with financial diligence typically allows you to secure the lowest interest rate. This not only helps lower your monthly payment, but also can save you thousands on the life of your loan. A 20% down payment also helps to secure a loan without costly PMI (private mortgage insurance) which is designed to protect the lender in the case of a foreclosure. PMI can really increase your monthly payment with charges of 0.5% – 1% of the entire loan amount on an annual basis. Your obligation of PMI continues until your loan balance reaches 80% of the original home value.
Another reason to consider saving and putting 20% down is to gain equity in your home. Remember the 2008 housing crisis? Many buyers found themselves not only house poor, but “upside down” in their mortgage from the loose lending that came partially from adjustable low-interest rates and no down payment options for those who couldn’t really afford to be homeowners. With the burst of the housing bubble home values decreased and were worth less than what was owed causing a negative equity situation and subsequent foreclosures. A moderate down payment of 20% ensures instant equity in your home and can safeguard you and your family from becoming a victim of another housing crises.
The combined benefits of securing the best long term interest rate, freeing yourself from years of PMI, and added security from an often turbulent housing market, makes a 20% down payment worth the patience and sacrifice in waiting. It can save you thousands of dollars in interest and mortgage insurance payments and giving you peace of mind if the housing market becomes unstable. If you want to look into other ways to save money long term, consider all repayment terms.
Normally, buyers will elect a 30 year mortgage to repay their home loan. If you feel you can afford to do it, paying the loan back in 15 years will save you a substantial amount of money over time. In order to determine if this is feasible, use a 15 year fixed mortgage calculator to see how monthly payments will look.
Other Down Payment and Loan Options
If a 20% down payment is not feasible for you, then there are other options requiring a smaller down payment available with certain eligibility requirements.
FHA loans are typically for low to mid income buyers who can’t meet the terms of the conventional loans because of poor credit scores, and lack of funds for a down payment. FHA loans require down payments as low as 3.5%, however, one catch is the buyer must carry PMI insurance for the entire life of the loan. An upfront premium of 1.75% is due at closing (or rolled into the loan), and annual premiums are paid monthly.
Conventional Loans can offer down payment options with as low as 3% with most requiring around 5%. While these loans can be more difficult to qualify for than an FHA loan based on credit history, they offer flexibility in the property you choose to buy along with a variety of loan options. Expect to pay PMI with less than a 20% down payment until you reach that in equity, but at a rate lower than the mortgage insurance for an FHA loan. So, in evaluating the interest rate with the FHA combined with the rate and terms of PMI, a conventional loan may be worth considering.
VA Home Loans are a borrowing option for active and retired member of the military, as well as spouses of the deceased military who died in active military or a result of a service related injury. These loans usually do not require a down payment, nor do they require PMI as the loans are guaranteed by the Department of Veteran Affairs. However, there is a one-time fee attached to the loan determined by the size of the down payment and whether you are active duty. While there is no income threshold requirement, buyers are expected to have a steady income to ensure mortgage payments, and enough left over each month to cover all other family living expenses. Also, there may be other criteria to meet determined by the private loan lender.
USDA Loans are no down payment low interest rate loans for buyers who purchase homes in rural and suburban areas. This low-profile subsidized program helps qualified low to moderate income buyers purchase homes in a “rural area’ determined by the USDA at a lower interest rate than conventional loans. Dependable income, a good credit history, and an acceptable debt to income ratio will determine eligibility as well as income limits set by location and size of a family. Although PMI is not required, there is an upfront premium required that can be financed into the loan.
One of the most difficult expense to pinpoint when buying a new home is the closing costs. These charges and fees come from a myriad of places and can vary by state, lender, and third party companies. Typically, you should count on closing costs ranging from 2-5% of your home value. Keep in mind that this does NOT include your down payment. For instance, if you are purchasing a home for $200,000, plan on paying $4,000 – $10,000 just for closing costs.
Within three days of applying for a loan, the lender will provide a standard Loan Estimate which will line item the loan terms (interest rate, monthly mortgage principal, and interest payment, etc.) as well as charges and fees associated with the loan which will be collected at closing. These fees include the lender’s fee as well as a myriad of charges and fees associated with purchasing a home such as: appraisal, inspection, title fees as well as any costs you will need to prepay at closing like homeowner’s insurance, mortgage insurance, property taxes, and several days of the loan interest. This estimate will be invaluable in bringing all information together to determine how much house you can afford.
Although determining the costs associated with purchasing a house can be difficult, our easy to use mortgage loan affordability calculator can assist you each step of the way in determining what house payment you can afford, your down payment and loan options, and keeping a close calculation of your closing costs. The more knowledgeable and prepared you are for the home buying process, the greater your chances are at buying the right and affordable home for you and your family.