If you're thinking of making the move from renter to homeowner, simply diving into home shopping is the wrong first step. What you need to do is first answer the question:
"How much house can I afford?"
The best way to determine your spending ability is to do a step-by-step calculation. While there are alternate rules of thumb for figuring out your housing budget -- such as a ceiling of 2.5 times your annual salary or limiting your housing payments to a third of your gross monthly income -- you should not take shortcuts on a financial decision as important as this.
Calculating ‘how much mortgage can I afford?’
Here are the major factors you will need to consider to determine how much house you can afford to buy:
- Income. First, add up the income that will be used to qualify for the mortgage, including bonuses and commissions. Make sure you have the documentation to prove every source of income; otherwise it cannot be counted when you meet with a mortgage lender.
- Debt. Add all the payments you make each month for car loans, credit cards, student loans and any other debt. Based on your income, there are limits on how much debt you'll be allowed to carry, including your mortgage. These debts will limit how much mortgage you can borrow.
- DTI ratio. When a mortgage lender calculates your level of debt based upon how much money you make, it is known as your “debt-to-income (DTI) ratio.” Debt-to-income ratios are the province of mortgage calculators. One important ratio, referred to by mortgage professionals as your "front-end" or "top-end" ratio, is calculated by taking your proposed housing expense divided by your gross (before-tax) income. Many mortgage calculators set 28 percent as the desirable value for this ratio. The other ratio involves all of your loan payments – your housing expenses and your monthly debts (but not utilities or other living expenses) -- divided by your gross monthly income. A home affordability calculator frequently set this number at 36 percent. This is called your "back-end" or "bottom-end" ratio.
- Monthly obligations. While your mortgage lender cares about your auto and credit card payments, they really don’t care whether you have cable TV, the latest iPhone or even that you eat on a regular basis. Those monthly expenses are up to you to include, and cable, smartphones and a few trips to the grocery store can easily add up to several hundred dollars each month.
- Down payment. The minimum down payment for an FHA loan is 3.5 percent; for conventional loans, the minimum is 3 percent for certain buyers and 5 percent for most buyers.
- Taxes. Today, it’s easy to get an idea on a home’s property taxes by looking at the listing online. You can also get in contact with the county tax office or ask a local Realtor to investigate for you. Most homeowners will have their property taxes paid from an escrow account attached to their monthly mortgage payments. One percent in taxes is equal to $1,000 per year for a $100,000 home.
- Insurance. Lenders require homeowners insurance to cover your property. Contact an insurance company or ask a Realtor to estimate your homeowners insurance costs which will vary according to the type of property, cost and features of the home, and its location. To get a rough idea, you can ask a family member or friend what they pay for insurance (if their home is similar to the home you are interested in buying).
- Homeowners association dues. If the property you purchase includes monthly dues, don't forget to include those fees in your monthly payments.
- Mortgage insurance. If you make a down payment of less than 20 percent on a conventional loan, you will need to pay mortgage insurance. You can utilize HSH.com's mortgage insurance calculator to see how much this could cost each month. For FHA loans, there is an upfront and annual mortgage insurance premium.
- Interest rate. You can check today's mortgage rates at HSH.com, but remember that your rate will depend on your credit score, the type of property you are buying, and the choices you make regarding fees and points. A lender will be able to give you a customized mortgage quote given your situation.
- Loan term. While many buyers opt for a 30-year home loan, if you can afford higher monthly payments, you may want to consider a shorter loan term. Shorter loans have lower interest rates and cost you less over the life of the loan.
As a homeowner, you need to have enough money set aside in an emergency fund -- at least three months worth of expenses – in case you lose your job or have a medical emergency, and enough reserves set aside to pay for maintenance and unexpected repairs.
Considering all your financial goals and your monthly comfort level with your mortgage payment is the key to accurately calculating how much house you can afford. It’s smart never to borrow the maximum amount you can qualify for so that you leave yourself some financial breathing room.
Michele Lerner and Gina Pogol contributed to this article.