Knowing how much you can (and should) spend on a home can be tricky. Most first-time home buyers may find themselves in a place where they’re not even sure where to start. Luckily, you're not alone.
Read on for a home budgeting guide that shows you what you need to know before getting into the market. Whether you’re ready to make a move right away or you’d rather save up for a while, by following these steps, you’ll be buying with confidence.
Figure Out Your Target Price Point
The first step in home budgeting is learning how far your money will go once you’re ready to hit the market. You can do this by researching available properties on home-buying websites. Start by thinking about the must-haves in your future home. These could be things like the number of bedrooms and bathrooms or a sizable yard. Then, look up comparable properties that are currently on the market in your area to get a sense of what you can expect to spend.
Once you have a target sale price in mind, take that number to a mortgage calculator. Use it to find your target loan amount and, based on that number, how much your monthly mortgage payment would be.
Calculate A Debt-To-Income Ratio
Here’s the secret to home-buying: Getting approved for a mortgage is all about your debt-to-income ratio. Essentially, mortgage companies want to make sure that you make enough money to guarantee you’ll be able to handle your current debts, plus a mortgage payment, without too much trouble.
When you’re starting to think about buying a home, it’s a good idea to calculate your debt-to-income ratio before starting to look at properties. That way, if you find you need to work on your finances before moving forward, you can do so at your own pace. You can either do this on your own or find a local lender to help.
If you feel comfortable flying solo, here’s how to calculate it:
1. Figure out your gross income. This is your provable take-home pay for the last two years, whether it’s salaried or hourly. Unfortunately, non-consistent additions like bonuses or overtime pay won’t be countable toward this number.
2. Add up your monthly payments. Skip your housing payments (for now), but take into account things like your car payment, student loans and credit card debts. To avoid feeling house-poor, you may also want to include projections for things like your monthly food and entertainment costs.
3. Look at your projected housing costs. Add together the projected mortgage payment you found earlier, plus estimates for other costs like utilities or property taxes.
4. Once you have these numbers, it’s time to calculate your ratio:
• Find your total debt by adding together your monthly payments and projected housing costs.
• Divide by your gross income. This number will give you a percentage, which is your debt-to-income ratio
Ideally, banks are looking for this ratio to be less than 36%. Keep in mind that there might be some flexibility, depending on which lender you choose. However, if the number you come up with is far above that percentage, you may want to work on paying down some debts, find ways to generate more income or adjust your price point accordingly.
Start Saving Where Needed
Having a sizable amount of savings is key when budgeting for a home. There are a few different places your money can go, such as:
• Your projected mortgage payment: If your projected mortgage payment is larger than your current rent payment, you may want to practice setting that money aside for a few months to make sure it’s feasible. After paying your rent, try putting the overage into a savings account.
• Your down payment: These days a down payment can be anywhere from 3%–20% of the home’s sale price, depending on the loan program you choose. Obviously being able to make a larger down payment will make you seem like a better bet to mortgage companies, but aim to have that 3% ready to go.
• Closing costs: Sometimes sellers will pay closing costs upfront, allowing buyers to roll their portion into their mortgage, but that’s not always the case. Typically closing costs will range between 2%–5% of a home’s sale price and you should be prepared to shoulder some of those fees, if needed.
• Additional savings: Buying a home shouldn’t leave you on empty. Make sure that you have some additional savings on hand so that you’re still prepared for any unforeseen living expenses.
Understand The Pre-Approval
Once you’ve done all of the above, you should be more than ready to apply for a pre-approval with a lender. This document is a guarantee of how much they’re willing to give you for a loan. Here, they’ll use your financial documentation such as W-2s, tax records, loan documentation and account statements to calculate a formal debt-to-income ratio.
After the lender has verified your financials, they’ll give you a pre-approval letter, stating how much they’re willing to lend you. Keep in mind that this number is the maximum amount for which you qualify. It may well be over the target price point you’ve budgeted for, but that does not mean that you have to borrow up to this amount.
On the off chance that your pre-approval comes back lower than your target sale price, you should work with your lender to figure out the best next steps to take. Often, they can offer targeted advice based on your unique financial situation that can help you get where you need to be.
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