A good rule of thumb is that you can likely afford a home that is worth about five to six times your annual salary. Of course, this means that having a stable source of income is important – it’s something that a lender will consider when deciding whether you’re a good risk.
You can get started assessing how much home you can afford by taking into account the following factors:
• You’ll want a clear idea of your current financial picture, including income, debt (auto, credit card, and school and other loans or payments like alimony or child support), and savings. As a rule of thumb, your total debt-to-income ratio shouldn’t exceed 43 percent, since you’ll also need to pay fluctuating monthly costs like utilities, gas, groceries, household needs, and other services.
• Your credit score is monumentally important when considering a home purchase. Some types of loans allow for a lower credit rating, but if your FICO credit score is on the low side (under 700), you should start trying to shore it up immediately – it can take a while.
• Lenders will also take into consideration past bankruptcies and defaults on loans, so be prepared to disclose this information unless 7 years have passed.
• You need to calculate how much you are prepared to offer as a down payment; it’s important to remember that if you are not putting at least 20 percent down, you’ll have to pay mortgage insurance, or MI to curb the risk incurred by your lender.
• The interest rate that you are able to secure from your lender, which is largely based on your credit score, should figure into your calculations. Run the numbers for several different rates based on the current range of available rates.
• Don’t forget that when you close the sale, you’ll be expected to pay certain closing costs. These include “points,” which you can pay at closing in exchange for a lower interest rate. If you plan on staying in a property for a long time, paying those points can save you a chunk on interest in the long run.
• You’ll need to take into account what you’ll be expected to pay in terms of homeowner’s insurance and property taxes.
• The terms of your mortgage (put simply, the number of years over which you agree to pay of your loan) will affect your monthly payments.
• Remember to take into account what kind of a home you are willing to buy. If it’s a fixer-upper, you aren't going to want to spend big on the property price, only to sabotage your ability to repair and remodel.
• There are many types of loans available (conforming, jumbo, FHA, VA). Some loan types don’t necessarily require 20 percent down. You’ll want to talk to a professional about which loans you might qualify for and which are your best options.
• When you find a house, do your homework. You’ll want to be aware of the “comps,” or comparable properties in the neighborhood to be sure you aren't being taken for a ride. If recent home sales in the neighborhood have gone for a few percent lower than asking price, you’ll want your bid to reflect that.
Be self-aware. Don’t sign up for a bigger mortgage than you can handle. If you know you have a weakness for spending big on clothing, eating out, travel, or other pursuits, you’ll want to take that into consideration. If you don’t have a lot of reserve in savings, don’t put yourself in a position where you’ll be unable to swing unexpected costs like repairs.
Running the numbers can give you an idea of whether you’ll prequalify for a loan; however, in order to obtain preapproval for a loan, you’ll need to submit an application as well as supporting financial documentation. If you can, get pre-approved by a lender before you even start shopping around for a home.
Many Internet calculators available to help calculate what range you can consider before you go home shopping. Once you have a ballpark idea of what you can spend, a lender can help you with the fine details of what you can afford. Be sure to find a mortgage lender who can help you shop around until you find the loan that is just right for you and will land you in the home of your dreams.