Your house is likely to be the biggest purchase you will make in your life, and you may spend years paying for it. Getting a mortgage to purchase a home can be a wise financial decision since you’re building equity and getting nice tax deductions. But buying a home that’s too expensive can leave you strapped and unable to prepare for other financial goals, like saving for retirement, kids’ college educations, or vacations.
Determining how much you can spend is the first step to responsible home buying. Consider these three questions to help you arrive at your magic number.
1. How much have you saved for a down payment?
Most mortgage lenders require you to pay a percentage of the purchase price as a down payment; that percentage can range from 5 to 20 percent. In many cases, if you put down less than 20 percent, you’ll likely be required to pay for private mortgage insurance, which usually costs .15 to .25 percent of the loan amount.
If you plan to sell one home and buy another, you may be able to apply any equity in your current home toward a down payment on the new home. If you’re a first-time homebuyer, taking time to aggressively save a down payment will pay off — a larger down payment will let you buy more house or make smaller monthly payments.
2. What monthly payment can you afford?
Most lenders recommend that borrowers spend no more than 28 percent of their monthly income on a mortgage payment. For instance, if you make $8,000 a month and owe $500 in monthly debt payments, you could get a 30-year mortgage of up to $380,000 with 5 percent interest. Your monthly payments, representing 28 percent of your income, would be $2,040. For help determining the right number for you, use an online mortgage affordability calculator like this one from Marketwatch.
Keep in mind that just because a lender is willing to loan you a certain amount doesn’t mean that you should borrow to the limit. You may not want to spend almost one-third of your monthly income on your mortgage. Write out a budget and keep in mind that you’ll need funds for home repairs, maintenance, and updates, as well as whatever else you want to spend your money on — vacations, savings, gifts, food, gas, etc.
3. What’s your credit history?
Your credit score will determine whether you qualify for a mortgage and what terms you’ll get if you do. Different lenders have different credit score requirements, but most expect borrowers to have credit scores in the 500s. For instance, FHA requires applicants to have a credit score of 580 or better to obtain maximum financing on typical new-home purchases, and offers some products with lesser financing for those with credit scores between 500 and 579.
If your credit score is too low to qualify for the mortgage rates you want, be patient. Consistently working to improve your score by checking for and resolving errors and methodically paying off debt can improve your score over time.
Once you’ve determined how much you can spend on a new home while still meeting other financial goals and obligations and avoiding the stress of excessive debt, you’re ready to start shopping.
Just remember to stay within your budget: Avoid the temptation to look at houses that cost more than you’ve committed to spend and you’ll be more satisfied with your home — and your whole financial life — in the long run.