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:
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 house you can afford
Here are the major factors you will need 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 card debt, 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.
- Down payment. The minimum down payment for an FHA loan is 3.5 percent; for conventional loans, the minimum is 3 percent for certain first-time buyers and 5 percent for other buyers.
- Taxes. Most homeowners have their property taxes paid from an escrow account attached to their monthly mortgage payments. Find out the local property tax rate to estimate your taxes. In some cases, that information is available online at the county tax office. 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 vary according to the type of property, cost and features of the home, and its location.
- 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, but remember 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.
When determining how much home you can buy, you need to make sure you are looking at your entire financial plan in order to avoid overspending. As a homeowner, you need to have cash reserves to pay for maintenance and unexpected repairs. You should make sure you have the ability to save for other emergencies and retirement, too.
Considering all your financial goals and your comfort level with your mortgage payment is the key to accurately calculating how much house you can afford. It's certainly OK not to borrow the maximum amount you can qualify for in order to leave yourself some financial breathing room.
Michele Lerner contributed to this answer