The answer to this complex question involves not only the initial costs of buying a home, but also your ability to keep up with the long-term financial responsibility of owning it. The process starts with making a list of the features you want in the home. Next, look at the neighborhoods and the surrounding amenities. Then, research the location's listings and the final selling prices. The information provides a good view of the market's activity and the cost of the homes in the area.
How Much House Can You Afford?
The typical industry formula is to calculate your potential mortgage against your annual income and current debt. This is called the 28/36 rule, and it determines how much of a mortgage you can qualify for.
The "28" (known as the front-end ratio) means your monthly mortgage payment (including taxes and insurance), shouldn't exceed 28% of your pre-tax income.
The "36" (known as the back-end ratio), means your entire debt load, which includes your mortgage as well as car payments, credit cards, student loans, and other monthly debt payments shouldn't exceed 36% of your pre-tax income.
Having a formula is nice, however what you can actually afford to buy will vary depending upon where you are buying (your geographic area), your spending habits, the cost of living in your region, and your overall financial health.
Out of Pocket Costs
Most homebuyers have no idea of the additional costs not covered in the mortgage loan. The out-of-pocket costs include the down payment, home appraisal, cash reserves and a home inspection.
- Down payment percentages range from 3-20% depending on the loan type.
- Appraisals average from $300 to $600. The purpose is to confirm the purchase price does not exceed the market value of the home. The seller may pay this fee. If the home appraisal comes in lower than the purchase price, it may be time to renegotiate.
- Cash reserves in the bank are dependent on the loan conditions. It's a safety net for the bank, preventing early defaults on a new loan.
- Home inspection cost is $200 to $400 and worth the expense before closing, since the seller may be obligated to pay for the repairs.
Total Cash Needed
The numbers may change depending on the lender, your credit and the seller. For example, on a $400,000 home with a 30-year fixed loan and 20% down (no private mortgage insurance), your reserves may need to include the loan principal and interest, annual real estate taxes, and insurance, along with a couple months of mortgage payments held in reserve.
Closing Costs
Closing costs typically run 2-3% of the loan amount, and can sometimes be negotiated with the seller to cover all or a portion of the amount.
Conclusion
Before you buy, make sure you run your numbers to make sure you will be 100% comfortable with your new mortgage payment. Also ensure you understand the terms and conditions of your loan, as they could significantly increase your out-of-pocket expenses. In addition, try to avoid closing delays, which could cost you prorated interest.
This article is for general informational purposes only and does not constitute personalized financial, tax, or legal advice. Benjamin A. Simerly, CFP®, founder of Lakehouse Family Wealth, offers advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Lakehouse Family Wealth is not affiliated with Cambridge.