7 Steps to Buying a House You Can Afford
By Scott Snider
THE MOST IMPORTANT TIPS TO BUYING A HOME YOU CAN ACTUALLY AFFORD
Buying a house, especially for first time homebuyers, typically begins with a sense of excitement. However, without a good plan and team around that buyer, that initial excitement can quickly turn into an overwhelming process. This is especially the case in competitive neighborhoods like Nocatee, Ponte Vedra Beach, Jax Beach, and Atlantic Beach, where the bidding wars can get out of hand very quickly.
It’s why having a plan of attack from the beginning is crucial to ensuring a successful outcome. After all, the ultimate goal of homeownership is getting that place you always dreamed of without that awful feeling of being house poor. With that in mind, my top tip for buying a house is this... Only pay for what you can afford.
Sounds simple, right? I’m sure some of you are probably saying “no kidding.” Unfortunately, due to all the moving parts that are associated with buying a home, buying what is considered affordable isn’t as straightforward as it may seem. Most new buyers are usually surprised to hear all of the other expenses that come with home ownership. To that end, a buyer needs to be mindful of such expenses as: the down payment, closing costs, title fees, mortgage payment, property taxes, homeowners insurance, private mortgage insurance (PMI), community development district (CDD) fees, and homeowners association (HOA) fees.
That was a mouthful. Keeping track of all of those various expenses can be confusing, even for seasoned homebuyers. So it’s easy to forget if you don’t write it down or keep a spreadsheet to help you stay organized. Really in order to build a smart plan, a buyer needs to understand how all these various expenses affect their budget and avoid unnecessary surprises. Those lesser known costs can quickly add up without proper organization, and before you know it you are strapped for cash and regretting your home purchase.
Being stuck with a house you can’t afford is stressful to even the most level-headed person in the world. Besides that it makes accomplishing other financial goals, like saving for retirement or putting money away for your kid’s college fund, an uphill battle.
The best way to avoid such regrets is to first set your targets in terms of the total monthly payment you can comfortably make, and then work backwards by adding in each cost to get an accurate estimate of your total monthly housing payment. Notice how I said housing payment, and not mortgage payment.
A great plan doesn’t leave anything out and rounds up any calculations where an estimate is necessary. This seems obvious, but it’s human nature to round down. We have a funny way of “rationalizing” our decisions when we really want something. Truthfully, the most essential part to planning for a home purchase is to set a minimum and maximum range for your down payment and housing payment.
BEST WAY TO ESTIMATE YOUR HOUSING PAYMENT
Let’s start with the housing payment first. However, it’s important to note that both types of payments go hand-in-hand because the amount you put down will affect your mortgage payment. So the question is what is an appropriate limit for a homebuyer that doesn’t know where to begin? A useful benchmark is a commonly used financial rule of thumb that limits a person’s housing payment (renting or owning) to 28% or less of their total gross income.
In other words, a family making $150,000 per year should limit their monthly housing payment to $3,500. Note that if other substantial debts exist, like student loans and expensive car payments, it is better to reduce this limit to 20% of gross income. That’s because your total debt-to-income ratio should never exceed 36% of gross income. A good example is someone with sizable student loan payments should keep their housing payments reasonably in-check. Otherwise, that person might be making 2 mortgage-like payments.
Once you know your housing payment limitations, you can then back into the purchase price you can afford by using Zillow’s mortgage calculator. Their calculators are a great resource because they capture all of the necessary housing expenses like the mortgage payment, homeowners insurance, property taxes, PMI, and association fees. You can even search by property and use that particular property’s market value data to get a more specific estimate of what that home will cost you.
HOW MUCH MONEY DOWN IS IDEAL?
In addition to setting limits on your housing payment, it’s also a good idea to set boundaries with how much money you put down. The ideal scenario for a buyer is to put 20% down because doing so ensures the borrower doesn’t pay the dreaded cost known as private mortgage insurance (PMI). Anything less than 20% will likely mean the borrower is paying PMI. This expense typically averages 0.50% of the borrowed amount (it can range between 0.3%-1.15% depending on a handful of factors) divided by 12. However, not every buyer has enough to cover such a down payment, which is why it’s okay to pay PMI if owning a home is the right long-term financial decision.
To put the magnitude into perspective, 20% down on a $400,000 home requires at least $80,000. It’s really going to be more than that because that $80,000 doesn’t include title fees and closing costs - additional fees that get lumped together with your down payment at closing. To anticipate such costs, I recommend using the following closing cost calculator. At any rate, the key to setting a limit with the down payment amount is knowing the price range of the homes you are looking to buy and be realistic about the cash on hand (or will have available from the sale of your old home) to cover such a down payment.
For example, let’s say you are buying a $400,000 house and have $50,000 in savings with little equity in your current home. Under these circumstances it would be wise to limit your down payment to 5%. Why? 20% is simply unrealistic unless the buyer is able to wait a couple years to allow them to save accordingly. Even 10% is too much.
There are 2 reasons: 1) the additional closing costs and title fees will deplete the remaining $10,000 in savings, and 2) it’s smart planning to always keep at least 3 months of living expenses in savings for a rainy day. Unfortunately in this scenario whatever remains in savings won’t cover the surprise expenses that are inevitable in life - like a roof repair or replacing a bad A/C unit.
To help summarize the key points, I created a DIY housing budget guide. Outlined below are the 7 steps you can follow to get a very good approximation of what you can afford to pay. However, for those who want an easier and quicker way to do it online, you can skip the 7 steps and corresponding example by using the following affordability calculator. Either method will help you “buy what you can afford.”
7 STEP HOUSING BUDGET GUIDE
1. CALCULATE MAXIMUM HOUSING PAYMENT
Cap it at 28% of gross income.
Total debt-to-income (DTI) ratio to never exceed 36%.
If DTI is above 36%, the housing payment needs to be lower than the 28% rule of thumb number so that all debt payments are equal to or less than 36%.
2. CONVERT HOUSING PAYMENT TO A LUMP SUM MORTGAGE ESTIMATE
Quick way to calculate - for every $100,000 borrowed at 4.5% on a 30-year mortgage, your payment will go up by approximately $500 per month.
Your monthly payment will also adjust $30 per month for every 0.25% change in interest rate on each $100,000 borrowed over 30 years.
3. ESTIMATE PROPERTY TAXES AND INSURANCE
Annual Property Taxes (Saint Johns County) = 1.088% of Purchase Price
Insurance Estimate = $35/month for every $100,000 in Home Value
4. CONVERT HOUSING PAYMENT TO A MORTGAGE ESTIMATE BY FACTORING IN PROPERTY TAXES AND INSURANCE
Subtract monthly cost of property taxes and insurance from housing payment in Step 1.
Convert the reduced monthly payment to an adjusted target price by using the $500/month for every $100,000 borrowed rule of thumb.
5. CALCULATE DOWN PAYMENT AND CLOSING COSTS
Down Payment = [Savings Account + Proceeds from Sale of Home] - [3 Months Living Expenses + Closing Costs]
A shortcut way to estimate closing costs is to multiply 2.5% by the price of the home.
Commission and variable incomes should keep 6 months of living expenses.
6. ADD BACK THE DOWN PAYMENT TO THE MORTGAGE AMOUNT TO ARRIVE AT AN ESTIMATED TARGET PRICE
Target Price = Mortgage Estimate + Down Payment
Almost there...other costs like PMI, HOA, and CDD fees are not yet included
7. RESEARCH PROPERTIES TO FILL THE COST GAPS AND ADJUST HOUSING BUDGET ACCORDINGLY
Search for properties through your realtor or sites like ZIllow to gather actual data
Make adjustments to your budget based on the other costs not yet captured, such as PMI, association fees, and community development dues.
PMI = [0.75% x Borrowed Amount] / 12
Association and community development dues vary by neighborhood.
Now that you have a 7 step process, how do you actually implement all of these budgeting tips? The best way for all of this to stick is to learn from a real life example and show you how to run the calculus.
Example: John and Suzie Jones are married with 2 kids and are looking for homes in the Ponte Vedra area. They are first-time homebuyers. The Jones’ have $75,000 in savings and make a $130,000 combined salary. Unfortunately, in her younger years Suzie switched majors at a private out-of-state college and was on the 6 year plan, therefore she has a sizable student loan payment of $1,200. Total monthly expenses, including all debts and rent, currently run them at approximately $7,000. Interest rates on 30-year mortgages are 4.5%. Given their lack of experience, the Jones’ are not sure what they can afford and need help figuring out their budget.
STEP 1 - TAKE 28% OF GROSS INCOME TO CALCULATE THE MAXIMUM PAYMENT, AND MAKE SURE ALL DEBT PAYMENTS ARE LESS THAN 36% OF GROSS INCOME
Housing Payment @ 28% = ($130,000 x 28%) / 12 = $3,033
Debt-to-Income (DTI) @ 36% = ($130,000 x 36%) / 12 = $3,900
Projected Debt Payments = $3,033 Housing + $1,200 Student Loan = $4,233
Projected DTI = $4,233 / ($130,000 / 12) = 39% → over the recommended level of 36%
Reduce Monthly Housing Payment = $3,900 Debt Limit - $1,200 Student Loan = $2,700
Recommended Monthly Housing Payment = $2,700
STEP 2 - CONVERT THE MAXIMUM MONTHLY PAYMENT INTO AN INITIAL ESTIMATED PURCHASE PRICE USING THE “$500/MONTH FOR EVERY $100,000 BORROWED” RULE OF THUMB
$2,700 / $500 = 5.4 (multiplier) → 5.4 x $100,000 = $540,000 max target price
Property taxes and insurance have yet to be included so the target purchase price will get reduced even further.
STEP 3 - CALCULATE PROPERTY TAXES AND INSURANCE
Property taxes = 1.088% x $540,000 = $5,875.20 → Monthly = $490
Insurance = $35 x 5.4 = $189
Total Taxes and Insurance Payment = $679
STEP 4 - REDUCE THE MAXIMUM PAYMENT BY TAXES AND INSURANCE, THEN CONVERT THE PAYMENTS TO A LUMP SUM MORTGAGE ESTIMATE
Mortgage Payment Estimate = Max Housing Payment - [Property Taxes + Insurance]
Mortgage Payment Estimate = $2,700 - $679 = $2,021
Mortgage Affordability Conversion = Mortgage Payment Est / $500 = multiplier x $100,00
Mortgage Affordability Conversion = $2,021 / $500 = 4.04 → 4.04 x $100,000 = $404,000
STEP 5 - ESTIMATE THE DOWN PAYMENT AND CLOSING COSTS
Initial Down Payment Estimate = $75,000 savings - (3 x $7,000) = $54,000
Closing Costs = 2.5% x $404,000 = $10,100
Proceeds Available for Down Payment = $54,000 - $10,100 = $43,900
This is a little over 10% of the purchase price, which means there will be PMI
STEP 6 - ADD BACK THE DOWN PAYMENT TO THE BORROWED AMOUNT TO ARRIVE AT AN ESTIMATED TARGET PRICE
Borrowing Target = $404,000
Down Payment = $44,000 (rounded up)
Target Price = $404,000 + $44,000 = $448,000
STEP 7 - RESEARCH PROPERTIES AND ACCOUNT FOR OTHER COSTS LIKE PMI, ASSOCIATION FEES, AND COMMUNITY DEVELOPMENT DUES - ADJUST HOUSING BUDGET ACCORDINGLY
PMI = [0.75% x $404,000] / 12 = $253 per month
Check listings for HOA and CDD fees → $150 per month
Total other fees = $403 per month
Adjustments to housing budget at a 4.5% interest rate for 30 years
Mortgage payment target = $2,021 - $403 = $1,618
Mortgage amount target = $1,618 / $500 = 3.24 x $100,000 = $324,000
Purchase price target = $324,000 + $44,000 (down pmt) = $368,000
RECAPPING THE KEY NUMBERS
Purchase Price Target = $368,000
Down Payment = $44,000
Mortgage Balance = $324,000
Housing Payment = $2,700
Mortgage Payment = $1,618
Escrows = $1,082
Property Taxes = $490
Insurance = $189
PMI = $253
HOA = $150
CONCLUDING THOUGHTS:
For a lot of readers, crunching the numbers is enough to make your head spin. Which is okay. Developing a well-thought out housing budget doesn’t come naturally. It is why I recommend leveraging the expertise of a realtor, mortgage loan officer, and financial planner, so that you have a team of professionals to help you get it right.
All three experts can help you keep more money in your pocket. A great realtor will ensure you negotiate a fair purchase price and don’t overpay for something. Then a well-qualified mortgage loan officer will help you structure the loan terms in a way that fits your unique situation. And after you find “the house,” it’s wise to have a financial planner confirm your decision by reviewing the short and long-term financial impact.
If anything else, the biggest take away to remember when shopping for a house is to only pay what you can afford. Buying a home is one of the biggest purchases you will ever make. Therefore, it is best to have a very targeted price and remain disciplined during the shopping phase. Doing so can make all the difference in landing your dream home actually becoming a reality.
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