The answer to this complex question involves not only the initial costs of buying a home but also your ability to keep up with the long-term financial responsibility of owning it. The process starts with making a list of the features you want in the home. Next, look at the neighborhoods and the surrounding amenities. Then, research the location’s listings and the final selling prices. The information provides a good view of the market’s activity and the cost of the homes in the area.
How Much House Can You Afford?
The typical industry formula is to calculate your potential mortgage against your annual income and current debt. This is called the 28/36 rule, and it determines how much of a mortgage you can qualify for.
The "28" (known as the front-end ratio) means your monthly mortgage payment (including taxes and insurance), shouldn't exceed 28% of your pre-tax income.
The "36" (known as the back-end ratio), means your entire debt load, which includes your mortgage as well as car payments, credit cards, student loans, and other monthly debt payments shouldn't exceed 36% of your pre-tax income.
Having a formula is nice, however, what you can actually afford to buy will vary depending upon where you are buying (your geographic area), your spending habits, the cost of living in your region, and your overall financial health. We believe the 28/36 rule could cause you to sacrifice your lifestyle for your home.
Debt guru, Dave Ramsey, believes you shouldn't do more than 25% of your take-home pay and that you should only use 15-year mortgages. Those on the east and west coasts may find following his rules to be a struggle.
The reality is your home value is likely somewhere between the 28/36 rule and Ramsey's recommendation. Our number 1 recommendation is to always remember this is a big decision that will affect your lifestyle (weekly spending, quality of vacations, and the number of adventures) for many years.
Out of Pocket Costs
Most homebuyers have no idea of the additional costs not covered in the mortgage loan. The out-of-pocket costs include the down payment, home appraisal, cash reserves and a home inspection.
- Down payment percentages range from 3-20% depending on the loan type.
- Appraisals average from $300 to $600. The purpose is to confirm the purchase price does not exceed the market value of the home. The seller may pay this fee. If the home appraisal comes in lower than the purchase price, it may be time to renegotiate.
- Cash reserves in the bank are dependent on the loan conditions. It's a safety net for the bank, preventing early defaults on a new loan.
- Home inspection cost is $200 to $400 and worth the expense before closing, since the seller may be obligated to pay for the repairs.
Total Cash Needed
The numbers may change depending on the lender, your credit and the seller. Let’s say you found a home and made an offer to purchase it for $400,000.
- You’re approved for a 30-year fixed loan with 20% down – no private mortgage insurance (PMI).
- Reserves may include the loan principal and interest, annual real estate taxes, and insurance, along with two months of mortgage payments.
- Total cash to buy this $400,000 home could reach $95,000.
Rolled into the loan are closing costs at 2-3% of the loan amount. Using the above sample – at 3%, fees could reach $10,000 dollars. You could negotiate with the seller to pay all or a portion of the closing costs.
Before you buy, make sure you run your numbers to make sure you will be 100% comfortable with your new mortgage payment. You shouldn't just think about are you comfortable today, but will you be comfortable as you live your life. Also ensure you understand the terms and conditions of your loan, as they could significantly increase your out-of-pocket expenses. In addition, try to avoid closing delays, which could cost you prorated interest.
Have questions about purchasing a home? We're here to help. Please feel free to reach out.
Storybook Financial is a financial planning firm determined to help those that believe in the betterment of the world around them. As a fiduciary, our service promotes unbiased financial planning with an emphasis on young medical professionals and their families. We are constantly pushing for new ways to give back to the Cystic Fibrosis community. We are based out of Iowa City | Coralville Iowa, but we serve clients nationwide with our robust virtual presence. This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.