articularly for those looking to buy their first home, the big question is
always, How much house can I afford. I can still remember my wife and I trying to crunch the numbers when we bought our first home back in 1993. I was scared to death that we wouldnt be able to afford the mortgage payments. But we did, and as the months and years went by, our mortgage payments became more manageable. If youre considering buying a home, it helps to have an idea of how much you can afford. Its very important to think of this question from two different perspectives. The first is simply how big of a mortgage will you qualify for. The answer to this question depends on a lot of factors, including your income, existing debts, interest rates, credit history and your credit score. Well look at several calculations that most lenders use to evaluate mortgage applicants. The second perspective is a bit more subjectivehow much home do you really need? Just because you can qualify for a mortgage, doesnt mean that you should. Banks will qualify you for as much as they possibly can given their existing underwriting policies. But just because the money is available doesnt mean you should take it. With that, lets look at 5 ways to calculate how much house you can afford, beginning with a standard rule of thumb:
can afford. For somebody making $100,000, the maximum purchase price would be $250,000 to $300,000. Keep in mind that this is a very general rule of thumb, and there are several factors that will influence the results. For example, the lower the interest rate you can obtain, the higher the home value you can afford on the same income. This is one reason why your credit score is so important. A good credit score of 760 or higher can net your an interest rate that is 1.5% lower than if you had a fair score of say 620. A 1.5% lower rate can easily translate into savings of tens of thousands of dollars over the life of a mortgage. If you dont know your credit score, you can get your FICO score for free from one of several credit scoring companies. Also keep in mind that some suggest higher or lower multiples. Ive seen banks recommend ratios as low as 1.5 times salary or as high as 5 times salary. I think that for most situations, a good starting point is 2.5x your income.
Even if your housing expense to income ratio is 28% or less, you still have one more hurdle to clearthe debt to income ratio. Also referred to as the back-end ratio, it takes your total monthly minimum debt payments and divides by your gross income. Debt payments include not only your projected mortgage, but also minimum credit card payments, car loan payments, school loan payments, and any other payments on debt. Bankers typically are looking for a back-end ratio of no more than 36%, although some will go a bit higher than this. To relate both the 28% and 36% numbers, here is a chart showing the calculations for various income levels:
$20,000 $467 $600
$30,000
$700
$900
$40,000
$933
$1,200
$50,000
$1,167
$1,500
$60,000
$1,400
$1,800
$80,000
$1,867
$2,400
$100,000
$2,333
$3,000
$150,000
$3,500
$4,500
Dave Ramsey takes a very conservative approach to home buying. If you can, he believes you should pay cash for a home. But if you do have to finance the purchase, Ramsey says you should finance your home with a 15-year mortgage and that your mortgage payments, including insurance and taxes, should be no more than 25% of your take home pay. He also believes you should not buy a home until you have a 20% down payment. If you decided to follow Daves approach, simply divide the amount of down payment you have available by .20. For example, if you have $25,000 saved for a down payment, the maximum amount you could spend on a home would be $125,000 ($25,000 / .20). Using this example, youd finance $100,000 on a 15year mortgage. At prevailing rates, and making some assumptions about insurance and taxes, the monthly payment would be about $1,000. Of course, youll also need the income to handle the mortgage payments. Here is a table of your maximum monthly payment under the Dave Ramsey approach to mortgages. Ive assumed take-home pay is 75% of gross income:
$20,000 $1,250 $312
$30,000
$1,875
$468
$40,000
$2,500
$625
$50,000
$3,125
$781
$60,000
$3,750
$937
$80,000
$5,000
$1,250
$100,000
$6,250
$1,562
$150,000
$9,375
$2,343
If you are a first-time home buyer, following Daves approach is going to be very difficult. Heck, it may be difficult if you are buying your second or third home. We certainly could not have bought our first or second home under these conditions, but its still an approach to consider.
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