I work with a lot of first time home buyers and have learned over the years that the one thing most of them have in common is they don't have a very solid understanding of what they can afford to spend on a new home. This is the first of a two part series to help you gain a better understanding of how to determine how much home you can afford.
Perhaps the most important thing to be aware of when trying to get a handle on this is that what you can afford, and what a lender is willing to lend you are often two very different things. In fact, you may be surprised to learn that most of the time, you can be approved for far more mortgage than you'll be comfortable paying. This is because lenders will use debt-to-income ratios to help determine how much of a mortgage payment you can handle, but the ratios don't usually include all of your additional household expenses. For example, if you have a gross income of $6000 per month (lenders base their ratios on before taxes income) car payments totaling $600 per month, and no other consumer debt, you may qualify for a total mortgage payment of approximately $3000 per month, including principle, interest, taxes, insurance, and mortgage insurance (if necessary). This is based on a total debt ratio of 60% ($6000/$3600 = .60); I've seen some loans approved with debt ratios as high as 65%!
Notice, however, that the debt ratio is only based on your prospective mortgage and your car payment. What's not included are other fixed ownership expenses, such as telephone, electricity, heat, water, cable, maintenance, etc. Also, living expenses like gasoline, health insurance, food, clothes, personal care, etc. are excluded from the ratio. Unfortunately, I've seen too many people over reach on their purchase price because they spoke with a mortgage consultant who told them that they "qualified" for much more mortgage than they could realistically afford.
So what can you do to gain a better understanding of your purchase budget? First, it's important to go through a complete budget work-up to get a thorough understanding of where all your money is currently being spent. The next step is to see if there's room to cut expenses, and decide whether you would be willing to change your lifestyle to accommodate those cuts. Next, make some educated estimates (ask friends and family about what they're paying) about unknown expenses like electricity, heat, etc., and come to a total monthly outlay exclusive of the mortgage payment. (Don't forget to include monthly savings.) You're now ready to start backing into a prospective mortgage payment. Subtract your total known and unknown monthly obligation totals from your total net monthly pay (weekly take home x 52 weeks ÷ 12 months) for your maximum monthly mortgage payment. Depending upon your income level and tax bracket, you'll want to pare the maximum figure down from anywhere between five and twenty percent.
Now that you have a working figure, it's time to put it to the test. I recommend that you actually begin making your mortgage payment months in advance by taking the difference between what you're paying in rent and what you believe you can afford for a mortgage payment (along with the other new expenses of homeownership) and putting it away in a savings account that you absolutely commit to leaving off limits. (After all, when you send the money to the bank to pay your mortgage, they're not giving some of it back if you happen to need it!) By doing this, you'll demonstrate to yourself whether or not you can actually live within the means of your new budget - this is not something you want to find about after you've purchased a home! Also, you will most likely have saved several thousand dollars in the process, which will come in handy once you've found a home.
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