Many existing homeowners or first-time homebuyers often ask themselves, “how much can I borrow?” This question does focus on a need for a budget, however prospective buyers or homeowners looking to refinance a mortgage should rather be asking, “how much should I borrow?” This is an important distinction that needs to be addressed to determine an amount that “comfortably” fits your needs.
What’s the difference between the two questions? The first question alludes to expanding your budget to the highest amount possible you can afford. But what happens if you run into another financial hardship and lose part or all of your income? Are your monthly savings enough to cover the mortgage payments for a few months until you are able to overcome the hardship?
Instead of trying to spend all your earnings on buying a home, a more modest approach is sometimes necessary. Aside from considering your regular costs such as utility bills, car insurance, health insurance etc – finding out exact mortgage costs you will be facing will help you determine whether or not the purchase is a sound financial investment. There’s no better way to be well-prepared for homownership than making a budget and sticking to it!
Most lenders consider a housing payment-to-income ratio of 28% a conservative estimate. The housing to payment ratio is referred to as your front-end debt-to-income (DTI) ratio and includes all expenses associated with the mortgage – including principal, interest, property taxes and homeowners insurance. To calculate an affordable front-end DTI, multiple 0.28 by your gross (pretax) annual income, then divide by 12.
In contrast, your back-end DTI is the percentage of your gross monthly income that is applied to all other installment debts (i.e. mortgage, student loans, car payments, credit cards, child support etc). The back-end DTIa shows the lender exactly how much of your earnings go towards your total debt obligations. Generally, lenders consider a back-end DTI of 36% or less an affordable amount.
FHA Loan DTI: In general, the FHA allows a front-end DTI of 29% of your gross monthly earnings, and a back-end DTI of 41%.
Remember to include all additional expenses when budgeting for a mortgage. These expenses include, but are not limited to:
Homeowners Insurance: costs may vary from location to location and this may be included in your monthly payment. According the National Association of Insurance Commissioners, in 2010 the average yearly premium cost for U.S. homeowners insurance was $791.
Private Mortgage Insurance (PMI): If you do not have a 20% down payment to purchase the home, you will more than likely be subject to pay PMI. This cost is embedded into your monthly mortgage payment.
Real Estate Taxes: All residential property requires the homeowner to pay property taxes – prices will vary from city-to-city. Taxes may be paid annually, twice a year, or paid monthly and are included in your monthly statement.
Down payment: A down payment is required to purchase real estate. Most conventional loans will require at least 20% down to obtain favorable terms and avoid private mortgage insurance. FHA loans may allow a down payment as little as 3.5% of the purchase price.
Closing Costs: Will vary from lender to lender, and also will depend if you are taking on a first or second mortgage. In addition to a down payment, lenders and third parties associated with the transaction will charge fees to close the loan. These fees may include loan origination fees, credit report fee, attorney fee, appraisal fee, underwriting fees, etc. In general, borrowers can expect to pay approximately 2-5% of the purchase price in closing costs.
Points: Mortgage points are an upfront loan cost that could save money through the life of your loan. The cost of a point is 1% of your total loan amount. The purchase of each point lowers your interest rate, thus making your mortgage more cheaper over time.
These are some of the major costs a homebuyer faces when buying a home. All of these factors should be considered when budgeting to buy a home. Once you have all the costs figured out, you’ll want to sit down with your lender or loan officer to locate a realistic mortgage option.