Trying to figure out how much house you can really afford can be a very complex question. If you are in the very beginning stages or even in the ‘dreaming’ stage of wanting to build or buy a home, we have put together 5 things to consider when planning for your future home. Keep in mind, we are not mortgage lenders, and highly recommend reaching out to one for the most personalized advice on preparing to buy or build a home.
1. Calculating Debt to Income Ratio
Debt to Income Ratio, or DTI, is a calculator that mortgage lenders use to determine the amount of mortgage debt a person can handle based on the monthly income and debt payments. The good news is if you would like to get an idea of what your DTI is before reaching out to a lender, you can do the equation yourself, or even use an online calculator like this one. You will want to add all of your debts together and divide it by your gross monthly income then multiply by 100 to get a percentage. Included in your monthly debt calculations should be credit card payments, mortgage/rent, student loans, and car payments. You won’t include monthly expenses like groceries, car insurance, or utility bills. Depending on the type of mortgage, you will need at least a 50% DTI, although if you have one of 36% or lower, you’ll have many more mortgage options. If you find that your DTI is too high, you can play with the equation to find out how much you should increase your income, or decrease your debts to get an ideal DTI.
2. Credit Score
The idea of a credit score can be especially intimidating since it accounts for many of the financial decisions you have made, including those unfortunate ones you may have made back in college and your early 20s. You don’t have to panic though, because, through time and persistence, you can help improve your credit score by reconciling old debts and reducing your credit card statement balance. If you are not familiar with what a credit score is, it is basically an overview of your financial health that helps lenders decide interest rates and eligibility. Scores range from 300 to 850 with different tier levels. It’s a good idea to compare your credit score with different lenders since there are various ways to calculate your score and you may fall under a better tier with one lender. As a general rule, the higher your credit score, the lower your interest rate, and monthly payments will be.
3. Use the 28%/36% Rule
Another way to get an estimate on how much you can afford is to use the 28%/36% rule. This measures the front end and back end DTI. The front end is the housing costs, mortgage payments, insurance, and property taxes and the back end are all your monthly debt payments. Front end DTI should be 28% or less and back end DTI should be 36% or less. To calculate the maximum monthly mortgage payment you can afford, multiply your gross monthly income by 28 and divide by 100 to reveal what your maximum monthly mortgage payment should be. Confused? Here's an example: (Say $6,000 is your gross monthly income in this example) 6,000 x 28 = 168,000 then divide by 100 to reveal a maximum monthly mortgage payment of $1,680. Remember, this is just a general starting point as it does not take into account your entire financial situation.
4. Down Payment/Closing Cost
Down payment can perhaps be one of the most intimidating parts of the home buying/building process. This is because it makes a big impact on how much you can afford based on how much you have to finance. Depending on your lender and what kind of loan you are applying for, down payments can range from 3% to 30%. If you’re unable to put down 20%, you’ll have to pay PMI, which stands for private mortgage insurance. This protects the mortgage company if you are unable to make mortgage payments. This is a fee attached to your monthly payment, typically at around 1% of the total loan value, so you will want to include this fee when considering how much house you can afford. Another cost you’ll have to save up for is the closing cost. This covers things like appraisals, inspections, credit reports, attorneys, homeowner’s insurance, etc. Typically, it’s about 4% of the purchase price, but your lender will give you an exact number. You won’t be able to avoid closing costs, but there are ways to minimize them. You can try negotiating with your lender for a fee reduction or ask if the seller would assume some of the costs, though they may raise the cost of the home to offset the cost. Some other incentives for closing costs are to take a higher interest rate, which is not ideal and it may be better to wait until you can save more money. Lastly, if you are building a new construction home, the builder may ask for a percentage of the home cost as a deposit at the time you sign the contract. It does depend on the builder, but we typically ask for 1% of the home cost at the time of signing. Regardless of where you land on down payment and closing costs, you will definitely want to include those when determining how much you can afford.
5. Ownership Cost
The last thing you want to do is move into your new home and not be able to afford the new costs of homeownership. Make sure you find out the average monthly costs of the utilities, or if it’s a new home, find out if electrical hookups are included in the price of your home. If you need to purchase new appliances, you’ll want to budget for that too. You will also have to plan for routine services in your home. If you are building or buying a home with A&E, you’ll rest easy knowing we have a one year home warranty to cover certain repairs that may come up.
BONUS: Quick Tips on New Construction Budget Planning and Loans
A new home construction loan that provides short-term funds that allow you to build your home, then convert into a long term loan is called a single-closing loan.
A two-closing loan requires a construction financing loan that closes when the house is built and then applying for a new loan for permanent financing.
If you already own a home and want to build a new home, you can apply for a bridge loan. These are short term loans that provide financing until your current home sells.
The best advice when it comes to preparing for building or buying is to make sure you create a realistic budget. It’s easy to get caught up in the desire for a perfect Pinterest home, but if you have a ‘must-have’ list a mile long, make sure you have the budget to back it up. If you don’t, then it won’t matter how perfect your home is because you’ll be stressed trying to make your mortgage payments every month. After you’ve got your credit score in good standing, know what your DTI is, and have saved for a down payment and closing costs, you’ll be able to budget accordingly for exactly what you can afford. We’d be honored to build a home for you that fits your lifestyle and your budget!
We hope this blog helps you get started on your plan for your future home. Planning to build or buy a home can be exciting, but also confusing. We’d love to help answer any questions you have or pass along the contact of our preferred lenders!