How Much House Can You Afford to Buy?

Mortgage interest rates are at historic lows as a result of one of the worst global recessions in modern times. The housing market remains sluggish, which has driven down the price of homes making them very affordable. Now may be one of the best opportunities to purchase a home, provided you can get approved for a loan. You may be asking yourself: Can I afford a mortgage?

Calculate How Much Money You Need

Here are a few steps that can help you answer that question.

1. Calculate Monthly Mortgage Payment

The first step is to estimate your possible monthly house payment when figuring out whether or not you can afford to buy a house. This is especially important for first time home buyers, who may not fully understand how a mortgage payment is calculated. It is imperative that anyone thinking of buying a home fully understand how much of a house they can afford, which starts with the principal and interest owed each month.

In order to calculate a monthly house payment, you first must have three pieces of data:

  1. current mortgage interest rates,
  2. amount of the loan, and
  3. length and type of the loan.

Since there are many different types of loans (e.g., fixed and adjustable), you may want to play around with the different rates and terms. Also keep in mind that the interest rate you find online or in a newspaper may be different than the one you are approved for. Rates vary for many reasons; including the region you live in as well as your credit history.

To keep things simple, let’s look at an example of purchasing a $150,000 home for a 30 year fixed rate mortgage. Let’s assume the home buyer has a good credit and can lock in a 30 year mortgage rate at 5.0%. Based on these details, we now have the necessary data required to calculate a fixed rate mortgage payment.

  • Loan Amount: $120,000 (80% of the price of the home — more on this later)
  • Interest Rate: 4.0%
  • Loan Terms: 30 year fixed

Once you have these details, there are many ways to calculate your monthly mortgage payment. The fastest and easiest way is to find an online calculator, such as the ones offered on Bankrate.com, or this mortgage calculator with amortization from Moolanomy.com. Using any basic online mortgage calculator, we find out that our monthly payment would equal $572.90, based on the loan details above.

Now the question you must ask yourself is, “Can I afford at least $572.90 per month for the next 30 years?” If the answer is no, adjust the loan amount down until you are comfortable with the monthly payment.

2. Add Property Taxes, Homeowners Insurance, and Other Costs

Once you are comfortable with your monthly principal and interest payment, you need to add in other recurring expenses like property taxes and homeowners insurance. These are just a few of the extra household expenses that are often combined into what is known as a mortgage escrow account. An escrow account is an agreement between the homeowner and a third party (your lender) in which money is deposited each time a payment is made. These funds are then used to pay larger annual or semi-annual expenses like property taxes and homeowners insurance.

Regardless if a homeowner decides to use an escrow account or not, paying for property taxes and insurance is unavoidable. In order to figure out these expenses, you may have to do a little homework to estimate your monthly escrow payment. A real estate agent may be able to help you estimate taxes and insurance on a potential home or sites like Zillow.com have helpful tools as well.

Monthly mortgage escrow expenses can run several hundred dollars per month, which means you must include them in your analysis.

3. Don’t Forget about Closing Costs

Another unavoidable mortgage related expense is closing costs. Fortunately, these costs are a one-time fee due at closing but you will still need to come up with the funds. Depending on the value of the home and the lender, closing costs can run several thousand dollars. In a down real estate market many sellers are offering to pay a buyer’s closing costs for them to get the home sold.

A homeowner can usually expect to pay about 1% to 2% of the cost of the home in title fees and closing costs. That is another $1,500 to $3,000 on top of the $150,000 home you were thinking of buying. Ask your mortgage lender for a good faith estimate on the closing costs you can expect.

4. 20% Down Payment

In order to avoid paying private mortgage insurance (PMI), a homeowner is usually required to put down a 20% down payment on their new home. While this ultimately reduces the total cost of the home (over the course of the loan), it also means you have to save some cash.

In order to avoid the PMI payment on the $150,000 home, the borrower would need to save up $30,000 and bring it to closing. This can be a significant expense for many potential home buyers and one that they may not be considering when asking the question, “Can I Afford a Mortgage?”

5. Miscellaneous Expenses

Don’t forget about all the other expenses that you may incur as a result of owning a home. Is the home in a neighborhood that has an HOA? If so, then you will need to account for home owners association dues. You will also have to factor in monthly utility bills like electricity and gas to heat and cool your home. If you are in a city, there is a good chance you will have a monthly water and sewer bill to account for.

Keep in mind that household related expenses don’t stop with the mortgage payment. There are always additional costs associated with owning a home.

Can You Afford It?

There may be no better time to purchase a home. With interest rates at record lows, the total amount of savings on a home compared to a few years ago is huge. That does not necessarily mean that you still be able to afford your dream home.

Potential home buyers must still ask the necessary questions and run the proper calculations. One must factor in all possibly expenses they will incur. There are monthly principal and interest payments, property taxes and insurance, closing costs, and down payments to consider. Then there are those other costs like paying for utility’s and HOA fees once you are living in the home.

Do yourself a favor and make sure you can afford to buy the home of your dreams before getting in over your head.



Author

By , on Oct 10, 2012
John Schroeder John Schroeder is the founder of PassiveFamilyIncome.com. He enjoys writing about passive income, debt-free living, and financial independence. He also enjoys sharing his experiences in raising a family on a single income, while his wife stays home with their two children. Aside from writing about money, he is an avid runner and enjoys spending time outdoors with his kids.

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{2 Comments}

  1. Kris:

    This is helpful for gaining an understanding. But once you are ready to go out and find a house, its a good idea to get pre-approved. That way you’ll get a better idea of how much you can afford. The amount you can borrow may be less than you think you can afford, in which case you need to find out why you qualify for less (bad credit? too much debt?). Or it may be more (so make sure you don’t use every penny on your mortgage). Either way you’ll get a more specific dollar figure.

  2. The USDA has a rural housing development program that gives loans with a subsidized interest rate. With our current income, we pay between 1 and 2% interest. We did not need a down payment. There are some restrictions (no used mobile homes, for instance), but it can help a family get a decent home.

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