For this segment we are going to focus on 2 simple rules of thumb, but more importantly the better-spending recommendations. We really want to hone in on the numbers here.
It’s easy to assume you can afford the same type of home your friends have. But that may or may not be true. You and your friends may have similar jobs and similar incomes but very different financial situations. Credit history, total debt, savings — these and many other factors help determine what type of mortgage you qualify for and how much home you can truly afford.
1st Rule Of Thumb
Annual Gross Income x 2.5
A long-standing rule of thumb states that if you take your annual gross income and multiply by 2.5, you’ll get an idea of how much home you can afford.
Let’s assume your annual gross income is 60,000. Multiply that by 2.5 and we get $150,000. This is how much you can realistically afford.
(IF YOU ARE NOT CARRYING DEBT)
Now, for those of us carrying significant amounts of debt, and have less than 20% down payment, think much less than $150,000. When apply for a mortgage banks will scrutinize you DTI (debt to income) ratio. Ideally, they what this number as low a possible, but will consider upwards of 43% DTI. Higher debt, plus a lower down payment also means that some lenders will require PMI (private mortgage insurance) tacked onto your mortgage payment.
2nd Rule Of Thumb
Monthly Gross Income x .28
This rule of thumb states that your total monthly mortgage payment (principal, interest, property taxes and homeowners insurance) should not exceed 28% of your monthly gross income.
Let’s assume your annual gross income is $60,000. Your monthly gross income would be $5000. Multiply that by .28 and we get $1,400. This is how much you can realistically afford. Which now beg the following questions:
- How does that compare to your current rent payment?
- Does it feel affordable?
- would you be caught short every month?
The above rules of thumb are an excellent start, but there’s even more room for improvement. follow our check list below to maximize your buying power and financial safety.
Sweeten Up The Debt To Income Ratio
- Rainy day funds -First, Have a $1-2000 emergency fund. The battle against Murphy’s Law is never ending.
- Credit Cards– Pay off all high interest revolving debt(credit cards and high interest loans)
- Auto payments– Pay off the car, if it will take too long, sell it. What do you want more, a place to live or a fancy car?
- Auto lease– get rid of it, its a waste of money that could be going towards you new home. Get a cash car, get a house, wait a year to adjust to your finances, then go get that fancy car.
- Personal loans– pay them all off, do not apply for a giant mortgage when you haven’t payed off a small personal loan.
- Student Loans – Stay current, pay the minimum, or defer the payment. But do not fall behind on payments. banks want to know that you have a good handle on your debt load. They will not turn you away simply because of high balance on your student loan.
Nail the above recommendation and you will look very enticing to lenders. They love borrowers who take all aspects of their finance serious. Show them that you can live within your means and still put away money. They will gladly shovel pre-approvals your way.
Calculate Your Comfort Zone
Let say your gross annual household income is $60,000, and monthly gross is $5000. These are nice flowery pre-tax figures. they don’t accurately represent our living expenses. Your after tax income will vary from person to person, family to family. Some of us pay alimony, child support, pensions plans, 401k, wage garnishes, dependent care etc,. For this example, let’s say your after take home pay is $46,000 annual or $3833 monthly.
- 1st rule of thumb: $46,000 yr x 2.5 = $115,000 home
- 2nd rule of thumb: $3833 mo x .28 = $1073 monthly mortgage
With the adjusted figures above you can clearly see that you can afford to have a home and save money every month. That extra money could mean, fancy vacations, fancy car for your new driveway, supplementing your retirement, college funds for the kids!
The numbers don’t lie. So let’s not fool ourselves when making one of the biggest financial decisions of our lives. Make sure that you and your spouse come to an agreement on the financial aspect of the home long before actually viewing properties. Spending an extra 5-10k may not be as painful to get into the right home, but don’t go as far as 30-50k. Stick around for our next segment when we break down the credit aspect of home buying.