The American dream of buying a home can end up being a nightmare if you buy too much house. To avoid being house poor, it’s crucial to calculate how much house you can really afford. Check out the video above for a simple roadmap that can help guide you through the process.
Follow the 28/36 rule
This is the income ratio that mortgage lenders use to determine your loan on the front end. Twenty-eight percent of your monthly gross income is what you should spend for all your housing expenses. This includes your mortgage payment, taxes, and insurance. For example, if you make $7,000 a month before taxes, 28% of that is $1,960. Your home should not cost you more than this per month.
“If you want to be comfortable and not feel strapped, it’s important to make sure your debts are in this range. Because after buying a home, there’s always more money to be spent on other expenses that are bound to come up like fixing something or buying things to fill up the space,” says Eric Rogers, a financial planner and founder of Beyond Your Hammock.
On the back end, the 36% refers to your total debt compared to your income. So add up all your monthly debt payments including credit card, students loans, car loans, alimony or child support. Even if your total debt is over 36%, it shouldn’t completely deter you from buying a home, says Scott Nadler, a mortgage specialist at Loan Depot.
Most lenders will go beyond the 36%, even up to 50%, but that’s definitely riskier, says Nadler. “But there are tax advantages for home ownership and it could be a wise investment, so take a look at your overall financial picture with an advisor to see if home ownership can benefit you.”
Make a list of everything you own
List all your assets including savings, investments, real estate, personal property like your car, and your retirement funds.
It’s not just enough to have money for a down payment – you’ll also need thousands for closing costs and fees. Ask your real estate agent to break down all the fees and provide a timeline so you can get a clear snapshot of what you’re responsible for and when.
On top of that, you’ll need a few months of cash reserves to be able to pay for your house after you’ve bought it.
With some homes you might have to show that you have 12 to 24 months of housing payments in reserves. “But for your own safety, while the bank might give you a mortgage with only with 2 months in reserves, you should think about having at least 3 to 6 months,” advises Barry Habib, a mortgage expert and CEO of MBS Highway. Because what if you lose your job or have to stop working because of your health? Your bills certainly won’t go away even if you want to stay.
Your down payment
Putting down 20% is best. Any less than that and you’ll have to pay for additional private mortgage insurance – that protects the lender in case you default on your loan. But you’ll only have to pay the PMI until you have 20% equity in your home.
Remember, the higher your credit score, the lower your interest rate will be. If your score is 720 or above, you’re in great shape to secure a competitive rate. A score of 680 and 700 is decent, but get below 660 and it gets a little tricky.
So the moment you start thinking about buying a home, start tracking your credit score monthly or even weekly – it’s free and it explains why your score is what it is. If you’re behind on payments, it lists them. If you’re using up too much of your available credit, it breaks that down. This way, you can work on getting your score as high as possible when it’s time to get that loan.
Jeanie is a reporter at Yahoo Finance. Follow her on Twitter @jeanie531.