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An Important Decision
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Getting Started
How Much House Can You Afford?
There is a rule of thumb that says that if you
have the capacity to repay the mortgage,
you can afford a single-family house that costs up to two and one-half
times your annual gross income. (Annual gross income is the amount
you make before taxes are deducted.) Like other rules of thumb,
this one is handy and can give you a general idea of how large a
mortgage you can afford. But, because it is so simple, it doesn't
take into account all the information that will help you feel comfortable
with your mortgage payments.
If you are buying a house with someone else (spouse, parent, adult
child, partner/companion, brother or sister or other relative),
you should consider your co-purchaser's earnings and existing debts
as well. Remember, if you apply for a loan with somebody else, you
and your co-borrower are both legally responsible for repayment
of the mortgage.
Your buying power depends on how much you have available for the
down payment and how much a financial institution will agree to
lend you.
Your
Down Payment
If you are a first-time home buyer, the price you can afford to
pay for a house may well be limited by your ability to come up with
the required down
payment and closing
costs. If you haven't accumulated much savings, you may
want to set aside funds for a down payment on a regular basis from
your paycheck. Monies in your checking and savings accounts, mutual
funds, stocks and bonds, the cash value of your life insurance policy,
and gifts from parents or other relatives may all be suitable sources
for a down payment.
Saving enough money for the down payment is usually the hardest
part of getting ready to buy a home, especially if you're a first-time
buyer. It often takes many years. Most first-time buyers must carefully
budget their spending to save enough for the required down payment.
Depending on the lender and loan type, you may
be able to get a mortgage with as little as 3 percent or 5 percent
down. However, putting less than 20 percent down often means you
will be required to purchase private
mortgage insurance. Private mortgage insurance helps protect
the lending institution in case you fail to make payments on your
mortgage. Typically, costs will be added to your monthly mortgage
payments and to your closing costs.
In helping you decide how much money you feel comfortable applying
to your down payment, you should consider moving expenses, home
decorating costs, and any needed upcoming "big ticket"
items (such a replacing a car). You don't want to move into your
new home with all your savings depleted.
In many cases, your lender will want you to have two months of
mortgage payments saved up as a cash reserve when you apply for
your mortgage.
Your
Closing Costs
In addition to the down
payment, you will also need to consider closing
costs. The closing (or, in some parts of the country, settlement)
is the final step during which ownership of the house is transferred
to you. The purpose of the closing is to make sure the property
is ready and able to be transferred from the seller to you.
Closing costs generally range from 3 percent
to 6 percent of the amount of the mortgage. So, if you were to buy
a $100,000 house with a 5 percent ($5,000) down payment, you could
expect to pay between $2,850 and $5,700 on your $95,000 mortgage.
Sometimes, you can negotiate with the seller of a property to pay
some of your closing costs, which will reduce the amount of money
you will need to bring to closing. (For a detailed discussion of
closing costs, see the "Closing
on Your Home section".
How
Much a Financial Institution Will Lend You
Apart from having available funds for a down
payment and closing
costs, the other major factor limiting how expensive a house
you can buy will be how much you can borrow. When you apply for
a mortgage, the lender will consider both your earnings and your
existing debts in determining the size of your loan.
Lenders generally use the following two qualifying
guidelines to determine what size mortgage you are eligible for:
- Your monthly expenses (including mortgage payments, property
taxes, insurance,
and condominium
or co-op
fee, if applicable) should total no more than 28 percent of
your monthly gross (before-tax) income. This is called the housing
expense ratio.
- Your monthly housing expenses plus other long-term debts should
total no more than 36 percent of your monthly gross income.
This is called the total debt-to-income ratio.
Basically, lenders are saying that a household should spend no
more than about one-fourth of its income (28 percent) on housing
and no more than about one-third of its income (36 percent) on total
indebtedness (housing plus other debts). Lenders feel that if they
follow these guidelines, homeowners will be able to pay off their
mortgages fairly comfortably.
These lender ratios are flexible guidelines. If you have a consistent
record of paying rent that is very close in amount to your proposed
monthly mortgage payments or you make a large down payment, you
may be able to use somewhat higher ratios. Some lenders offer special
loans for low- and moderate-income home buyers that allow them to
use as much as 33 percent of their gross monthly income for housing
expenses and 38 percent for total debt.
When you go to apply for a mortgage, the lender
will use all the relevant data -- your income, your existing debts,
the purchase price of the house, your down payment, the
interest
rate on the loan, and the cost of property taxes and insurance
-- and calculate whether you qualify to borrow the amount of money
you need to buy the house.
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