How to Calculate How Much House You Can Afford

Before you buy a house, you need to determine whether you can afford it so that you can qualify for loans and avoid foreclosure down the line.

Steps

1. Determine if you have an adequate down payment. You will usually only be allowed to borrow 80-90% of the appraised value and your down payment will have to cover the difference between that and the selling price.[1] (Note that the appraised value may be higher or lower than the selling price of the house.) If you have $30,000 saved for a down payment, for example, you can use it as a down payment for a home between $300k (10% down payment) or $150k (20% down payment). Putting down less usually requires you to pay private mortgage insurance (PMI), which increases your monthly housing cost but is tax deductible.
2. Find out what ratios lenders are using to determine if you qualify for a loan. "28 and 36" is a commonly used ratio.[2] It means that 28% of your gross income (before you pay taxes) must cover your intended housing expenses (including principal and interest on the mortgage, as well as real estate taxes and insurance). Monthly payments on your outstanding debts, when combined with your housing expenses, must not exceed 36% of your gross income. Find each percentage for your monthly gross income (28% and 36% of $3750 = $1050 and $1350, respectively). Your monthly payments on outstanding debts cannot exceed the difference between the ($300) or else you will not be approved.
3. Calculate your expected housing expenses. Estimate the annual real estate taxes and insurance costs in your area and add that to the average price of the home you'd like to buy. Also add how much you can expect to pay in closing costs. (These take in various charges that generally run between 3 to 6 percent of the money you're borrowing. Credit unions often offer lower closing costs to their members.) Put the total into a mortgage calculator (you can find them online or make your own in a spreadsheet. If the figure is above 28% of your gross income (or whatever the lower percentage used by lenders in your situation) then you will have a hard time getting a mortgage.
4. Look into home-buying programs which could make the process more affordable.
   
   • If you qualify, check out first-time buyers' programs, which often have much lower down payment requirements. These are offered by various states and local governments. You may also be able to access up to $10,000 from your 401(k) or Roth IRA without penalty. Ask your broker or employer's human resources department for specifics regarding borrowing against those assets.
   • If you can't afford a 10%-20% downpayment on your home, but have good credit and steady income, a mortgage broker may assist you with a combination mortgage. In that, you're taking out a first mortgage up to 80% of the value of the home, and a second mortgage for the remaining amount. While the rate on the second mortgage will be slightly higher, the interest on it is tax-deductible and combined payments should still be lower than a first mortgage with PMI. If you're buying new, consider the Nehemiah Program to get assistance with your down-payment.

Tips

• Consider whether you need to sell your current home in order to afford a new one. If so, any offer to buy that you make will be contingent on that sale. Contingent offers are more risky and less desirable for the seller, since the sale can't be completed until the buyer's house is sold. You may want to put your current house on the market first.

Sources and Citations

1. ↑ http://www.federalreserve.gov/Pubs/mortgage/MORBRO_2.HTM


2. ↑ http://www.federalreserve.gov/Pubs/mortgage/MORBRO_2.HTM

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