THE IMPORTANCE OF KNOWING YOUR BUDGET
Buying a home is a significant financial commitment, and determining your budget is the first step towards a successful home-buying journey. By knowing your budget, you can set realistic expectations and avoid falling in love with a property that is beyond your means. Purchasing a home that fits comfortably within your budget will provide financial security and peace of mind.
To calculate how much house you can afford, you need to consider several factors, including your income, credit score, debt-to-income ratio, and down payment. Let’s break down each step of the calculation process.
Step 1: Evaluate Your Income
Start by assessing your monthly take-home pay. This is the amount you receive after taxes and other deductions. Financial advisors often recommend spending no more than 25% of your post-tax income on housing costs. This payment will need to include interest, principal, insurance, and taxes. To get a rough estimate of your affordable monthly mortgage payment, multiply your total household income by 0.25.
For example, if your monthly take-home pay is $5,000:
$5,000 x 0.25 = $1,250
Based on this calculation, your maximum monthly mortgage payment is around $1,250.
Step 2: Check Your Credit Score
Your credit score plays a crucial role in determining your eligibility for a mortgage loan and the interest rate you will receive. A higher credit score generally translates to better loan terms. Before applying for a mortgage, it’s essential to check your credit score and address any issues that may negatively impact it. You can obtain a free credit report once a year from AnnualCreditReport.com or by contacting the three national credit reporting agencies: Experian, Equifax, and TransUnion.
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Step 3: Gather Financial Documents
To get an accurate picture of your financial situation, you’ll need to gather several documents, including:
- Monthly and annual household income
- Credit score
- Existing debt (credit cards, car loans, student loans)
- Savings and investments (for determining your down payment)
- Property taxes for the area you’re interested in
- Current interest rates
- Homeowners insurance costs for the area you’re interested in
Having these documents ready will streamline the prequalification process and enable you to make informed decisions.
Step 4: Use an Affordability Calculator
Once you have your financial information in order, it’s time to use an affordability calculator. These tools consider your income, debt, and other factors to estimate the home price and monthly mortgage payment you can afford. By entering the necessary information, you can experiment with different loan terms and down payment amounts to find the most suitable option for your budget. Click here to access the TruWealth Home Affordability Calculator.
Remember that an affordability calculator provides an estimate, and you should consult with a mortgage lender for a more accurate assessment based on your specific financial situation. Additionally, you should meet with a financial advisor to discuss the long-term impact of a home purchase on other goals such as retirement, children’s education, death, disability and more.
Step 5: Assess Your Debt-to-Income Ratio
Mortgage lenders assess your debt-to-income (DTI) ratio to determine your ability to manage mortgage payments alongside other financial obligations. The lower your DTI, the better your chances of securing a loan. To calculate your DTI, divide your minimum monthly debt payments by your gross monthly income and multiply the result by 100.
Below are examples of debt to include when calculating your DTI. Only use the minimum monthly payment amounts for the following — not the balance nor the typical amount you pay:
- Your rent or monthly mortgage payment
- Property taxes
- Homeowners insurance payments
- Homeowners association (HOA) fees
- Auto loan payments
- Student loan payments
- Credit card payments
- Child support or alimony payments
- Personal loan payments
For example, if your monthly debt minimum payment totals $2,000 and your gross monthly income is $5,000:
($2,000 / $5,000) x 100 = 40%
A DTI ratio below 43% is generally preferred by lenders, but lowering your DTI can increase your chances of loan approval and provide more financial flexibility.
Step 7: Consider Fees and Closing Costs
When purchasing a home, it’s crucial to account for various fees and closing costs. These expenses can include appraisal fees, attorney fees, inspection fees, origination fees, underwriting fees, and title fees. Additionally, you may encounter fees for loan applications, credit reports, and property surveys.
While some sellers may agree to cover a portion of the closing costs, it’s wise to budget for these expenses to avoid any surprises. Research typical closing costs in your area and factor them into your overall budget.
Step 8: Determine Your Down Payment
Your down payment significantly affects the amount you can afford to spend on a home. The more you can put down, the less you’ll need to borrow from a lender, resulting in lower monthly payments and potentially better interest rates. Aim for a down payment of 20% or more to avoid private mortgage insurance (PMI) and reduce the overall cost of your mortgage.
Keep in mind that there are loan options available with lower down payment requirements, such as Federal Housing Administration (FHA) loans and U.S. Department of Veterans Affairs (VA) loans. However, these loans typically involve additional costs, such as mortgage insurance premiums.
Step 9: Save for Unexpected Expenses
Owning a home comes with additional costs beyond the mortgage payment. It’s crucial to have an emergency fund to cover unexpected expenses such as repairs, maintenance, and home improvements. Financial experts recommend having three to six months’ worth of mortgage payments saved in an emergency fund to ensure you can handle any unforeseen circumstances without compromising your financial stability.
FINDING YOUR DREAM HOME WITHIN YOUR BUDGET
By following these steps and understanding your budget, you can confidently start your home search. Work with trusted real estate professionals who can guide you through the process and help you find properties that align with your budget and preferences. Remember to stay within your means and prioritize financial security when making one of the most significant investments of your life.
CONCLUSION
Calculating the affordability of your dream home is an essential step in the home-buying process. By evaluating your income, considering your expenses, and factoring in your financial goals, you can determine a realistic budget that aligns with your long-term financial well-being. Don’t rush into a decision and always consult with professionals to ensure you make informed choices. With careful planning and a solid understanding of your financial situation, you can find a home that not only meets your needs but also provides financial stability and peace of mind.
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Additional Resources:
- See our Home Affordability Calculator.
- Check out our other Mortgage Calculators.
Disclosures
TruWealth Advisors, LLC is an SEC registered investment adviser located in Louisiana. Registration does not imply a certain level of skill or training. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or financial advice. You should consult your own tax, legal and financial professionals before engaging in any transaction. Past performance does not guarantee future results. Additional information about TruWealth Advisors, including our registration status, fees, and services is available on the SEC’s website at https://adviserinfo.sec.gov/firm/summary/306876.