Can you help me? My husband and I would like to buy our own home. How do we know if we can afford it?
Donna's smart! It's always better to find out if you can afford something before you begin seriously shopping.
So how does Donna determine if they can afford to buy? Answers to a couple of questions can help them decide. First, do they have enough savings to get into a home? Second, can they afford the regular, ongoing monthly expenses?
Let's begin with the first question. How much would it take for them to get into a home? Affording a home means more than having enough cash for a down payment. Initially Donna will need enough savings to cover a down payment, the closing costs, and some initial expenses like utility deposits.She'll also need some cash for some of the expenses that come with a first home. Things like a lawnmower, ladder and basic lawn implements. Home centers love first-time homeowners!
Naturally, the down payment is the biggest item. It usually runs from 5% to 20% of the price of the home, but Donna can expect to pay higher interest rate if her down payment is lower. She probably should plan for about 10%.
Many mortgages have fees or "points" associated with them. It's not unusual for that to add 2% to the amount that she'd need at closing.
Closing costs vary by locale and by what you negotiate in the contract. She can use 3% as a guesstimate, but that could be off by as much as 2% depending on the circumstances of her contract. Some places customarily allocate more expenses to the buyer than other places. Donna should ask someone in the real estate industry what costs are typically paid by the buyer in her area.
A few quick calls to the utility companies should give Donna an idea of any deposits or set-up charges that will be required.
Once Donna has determined if they have enough money to get into a house, she'll need to figure out if they can afford to hang onto it.
Most experts say that housing expenses shouldn't exceed 35% of your after-tax, spendable income. Donna can calculate her annual after-tax income using her payroll check information. In fact, unless she got a large IRS refund or had to write a large check last April, she probably can use the net figure from her paycheck. All she needs to do is to figure out how many paychecks she'll get in a year and then multiply her after-tax pay by that number.
Another benchmark that some advisers use is to total all debts and then compare that to income. The reason is simple. The part of her paycheck that Donna has already committed to car payments or credit card minimums is not available to pay the mortgage. Typically experts suggest keeping total debt payments to less than 40% of Donna's income. If her estimate of a mortgage added to her existing payments exceeds 40%, she might be wise to try to pay down some debt before she begins house hunting.
There's another more accurate way to gauge Donna's ability to handle the monthly expenses. That's to create a "make believe" budget that included a house payment. She would take her current budget and just replace her renter's expenses with the mortgage payment and other homeowner's expenses. Don't forget to include taxes, insurance and some money each month for home repairs.
If Donna is close but can't quite get the numbers to work, she could check out some lower cost alternatives. Foreclosures or "handyman's specials" could offer an opportunity. She might also want to consider buying a duplex and renting one side while living in the other.
Finally, if she does decide to buy, Donna will want to check her credit report before she begins shopping. That will give her an idea of how she'll look to a mortgage company. A FICO score of over 700 should put her in good shape. She'll be able to find a mortgage with a score in the 600's or even 500's, but the interest rate will be higher.
She should also check her credit report for errors. About 25% of all credit reports contain an error significant enough to effect the interest rate on a mortgage. If Donna finds an error, she'll want to get it corrected before she begins shopping for a home or a mortgage.
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