Know How Much House You Can Afford
The purchase of a home gives you several important financial benefits. First, there is an opportunity to build equity. With every mortgage payment, some of the money that was borrowed (principal) is repaid. This, along with generally increasing home values, increases home equity, which is the difference between the market value of a home and its outstanding debt balance.
A second financial benefit is tax write-offs. Mortgage interest and property taxes on a principal residence are deductible if you itemize income tax deductions (however, be aware of changes to the tax law as of 2019).
A third financial benefit is leverage, which is the use of other people’s money to magnify potential financial gains.
Determine How Much House You Can Afford
- When determining how much house you can afford, most lenders use some variation of the “28/36 Rule.” This means that PITI (principal, interest, taxes and insurance) cannot exceed 28 percent of gross monthly income. PITI plus all outstanding consumer debt (such as car loans and credit card payments), cannot exceed 36 percent of gross income. For example, a dual-income couple earning $60,000 annually, or $5,000 a month, would qualify for a mortgage with a $1,400 monthly PITI payment ($5,000 x .28) if they had no other debt and a $1,200 monthly payment if they had $600 of monthly consumer debt payments ($5,000 x .36 = $1,800 - $600 = $1,200).
- If you are unable to afford a home within these guidelines, continue saving to increase your down payment while repaying consumer debts. Also inquire about loan programs for first-time buyers.
- It may take a year or more to accumulate enough cash to qualify for a mortgage on a starter home. Do not expect to purchase a large house with upscale features the first time around.
- Beware of '100 percent' mortgages. Before you apply for this type of loan, be sure you understand the risks. Visit FINRA to learn more.
- You'll need to save for closing costs, which can amount to several thousand dollars.
- Before shopping around, get preapproved by a lender, not just prequalified. Prequalified simply means that your income fits the debt-to-income ratios described above. Preapproved means that a lender has verified your income, checked your credit and agreed in writing to provide a mortgage up to a certain amount.
Follow the 'Rule of Three'
- For every required service — such as a realtor, mortgage lender, home inspector, property insurance company and attorney — compare at least three competing firms. Ask friends, family and coworkers for referrals. It is especially important to compare realtors, as they ikely will recommend contacts for the other services; you want to make sure it is someone you can trust.
- Compare service providers according to their reputations for customer service as well as fees and interest rates.
- Use the internet to shop around efficiently. Current mortgage interest rate information can be found at www.hsh.com and www.bankrate.com. The web site www.realtor.com provides information about buying and selling a home and the ability to do extensive property searches anywhere in the country.
- Another reason it is so important to compare realtors is that, while they work closely with buyers to show houses for sale, they generally represent sellers because their objective is to promote a sale and earn a commission. Therefore, be careful of saying anything to a real estate agent that might divulge your negotiating strategy.
- When you're determining how much house you can afford, don't forget about insurance. Purchase liability limits of at least $300,000 ($500,000 is better) on homeowner’s insurance and adequate coverage to rebuild your home in the event of a loss. A property and casualty insurance agent can assist you with these decisions.
- Consider an umbrella liability policy with up to $1 million, or even $5 million, of liability coverage and extra life insurance to make sure there will be enough money to pay off the mortgage.
Make Sensible Improvements
- If your first house won’t be your last house (and it probably won’t be), make home improvements that pay off to build equity for resale. Some renovations, such as adding a bathroom, landscaping or remodeling a kitchen, can significantly increase appraisal values compared to other renovations such as an extra bedroom or a pool.
- Beware, however, of “over-improving” a house. A general rule is that you cannot expect a house to sell for more than 20 percent above the neighborhood average.
[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education.]