You've spent years saving, and the time has come for you to purchase a home, Hooray! You start searching online and quickly realize that you have no idea what your price range to look at. Well have no fear, we are here to take away all...well, most...of the guesswork.
First thing's first. All that money you've been saving, how much of it are you willing to put towards a down payment? If you're like most people, you don't want to put all of your savings towards a down payment, and fortunately, most banks won't allow you to do so. They recognize, and you should as well that there are additional costs that you incur with the purchase of a home, unrelated to your mortgage, be it closing costs, the moving company, and furnishing your new digs, not to mention any other expenses you might have. Having a new homeowner default on their loan because they did not have enough in the bank is not good business.
Now that you have that down payment amount in mind do the houses that are 5x that amount something that you can see yourself in? The reason we ask this question is that for a conventional mortgage, banks will look for you to pay 20% of the price of the home as a down payment. Anything less than 20% will require that you have Private Mortgage Insurance (PMI). PMI generally runs at 0.5% to 1.0% of the loan amount, so on a $500,000 loan, you could be looking at an additional $400 per month just because you don't have the 20%.
An alternative to the conventional mortgage if you don't have the 20% to put down is a Federal Housing Administration (FHA) loan. FHA loans are designed to allow individuals without the necessary savings to put 20% down or with poorer credit to purchase a home. These loans are not without restrictions including minimum down payment of 3.5% or 10% based on credit score, income limits, and overall cost of the home. These restrictions vary from State to State and may differ town to town based on local factors.
Now that you have an idea as to how much house you can afford based on your ability to make a down payment, it's time to think about how much you want to spend on a monthly basis for housing. While you may have a fair bit of savings by living with parents, from an inheritance, or generally being smart with your money, you may not have the resources to pay for a mortgage and taxes and maintain the lifestyle that you want.
Take a look at your current income and expenses and determine how much you are willing to pay each month. This number should be your limit for mortgage, property tax, and insurance. When you pull up most Mortgage calculators online, they only calculate the mortgage portion, so don't be fooled into thinking that is all you will be paying each month.
Let's go back to our earlier example of taking out a $500,000 30-year mortgage with 20% down. Using an interest rate of 4.0%, you are looking at a monthly mortgage payment of $2,387. "Great!" you say to yourself "I have a budget of $2,500 per month. I can totally afford this house." Not so fast. Depending on where you live in the country, property taxes could add an additional 30% on top of that, pushing your monthly living expenses over $3,000. Here in Connecticut we have some of the highest property taxes in the country, but even here, tax rates vary pretty significantly, so it's smart to check the taxes in your towns of interest before deciding on your price point.
In many cases, property taxes can be paid by your mortgage company and included in your monthly bill. The way this works is that each month a portion of your payment to the mortgage company will be deposited into an escrow account, and then when property taxes are due, the mortgage company will pay them for you. This simplifies payments for you, and makes it so that you are never late paying your property tax, and run the risk of having a lien placed on your home for those taxes.
The 4% that we are using for our calculations is a ballpark number for a 30 year interest rate in mid 2019 for someone with credit a credit score over 740. These rates typically track very closely with the 10-Year Treasury Rate. Lower credit will increase your rates. Regardless of your score, you should speak with a broker or your bank to determine final rates.
Getting back to how much house you can afford, you'll want to compare the numbers that you've come up with for a price based on down payment and the price based on your monthly budget, with the lesser of these two numbers being what you can afford.
Price based on down payment: $125,000 * 5 = $625,000
Price based on budget: $2,500 -> $2,000 Mortgage + $500 taxes -> $420,000
So while you have sufficient funds to make a down payment on a $625,000 home, your budget does permit for such a price. Generally these numbers are a little closer than we have here, but as we saw before, bumping up your budget $500 would put you right about $625,000, so with some shifts in your budget, you may be able to afford more, but that is up to you.
Now if you make some shifts in your budget and decide that you can afford the $625,000 home, the banks may still disagree. Before you start seriously looking at homes, it is a good idea to get pre-qualified, or even pre-approved by a lender.
Pre-qualification is an informal process, where you answer a few basic questions , and pre-approval is more in depth, and can give your agent and the sellers a peace of mind, knowing that you are very likely to be able to purchase the home that you make an offer on.
Just because you are pre-approved, that does not necessarily mean that you will secure the mortgage that you apply for, and it is important for you to not use too much of your available credit, make big purchases, or anything that could negatively impact your credit going into the home buying process, and especially, not while your mortgage application is under review.
If you have any additional questions about the mortgage application process or are curious how far your money will go in any of the towns across Fairfield County, Connecticut, my agents and I are at your service.
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