Can You Afford to Buy?

There are three reasons why you should not buy a house:

1) You can’t afford it
2) You can’t afford it
3) You can’t afford it

Other than those reasons, of course you should buy a house!

Whether you're a first-time buyer looking for the perfect starter house, or a seasoned pro trading up to your waterfront dream home, you are probably asking the same questions: Can I afford this? And is this the right move at the right time?

In a hot real estate market, some might say the question is not "Can I afford this home?" but "Can I afford not to jump onto the climbing real estate escalator?" Aside from building equity over time and benefiting from the tax breaks of home ownership every April 15, everybody pays rent — the difference is whether the landlord is yourself or someone else.

Planning to Make a Move
One of the best places to start is with a detailed expense breakdown. Analyze what you spend — at least get a full month's snapshot. You’ll see where you may have wiggle room in your budget and what you can afford for housing. (Be sure to count all those little incidental expenses like dry cleaning and yes, those mid-afternoon Starbucks lattes count in the budget, too!)

Real Life Example
This sample budget belongs to a single, 35-year-old woman making $68,000 per year, renting a two-bedroom apartment. Her monthly pre-tax income is $5,667.

Monthly expenses: Rent $1,600
Car payment $225
Credit card payments $200
Car insurance $75
Groceries $400
Health insurance/renters insurance $208
Electricity $40
Natural gas $70
Cell phone $49
Home phone + Internet access $72
Cable TV $50
Gas, dining, clothes, dry cleaning, gifts, other expenses $800
Memberships (gym, professional, etc.) $100
Water/sewer/garbage $0
Property tax/homeowners insurance/condo fees $0
Alarm company $0
Lawn $0
Total $3,889

The sample budget may not look like your expense snapshot, but by adding and subtracting your personal budget items with an eye toward true monthly out-of-pocket totals, you get a pretty good picture. Now, add in all of the expenses where the zeros are as well as the increased cost of your monthly mortgage payment (formerly rent). Maintenance costs like condo fees, utilities, the leaky bathroom sink that defies a simple trip to Home Depot to fix, property taxes, closing costs, and furniture for your new home all add to the bottom line.

Debt-to-Income Ratios

If you can comfortably afford the existing $1,600 rent (or existing mortgage if you are trading up), chances are you’ll qualify for a mortgage in the same range, or even higher. Lenders will determine how much loan you can afford by using debt-to-income ratios — basically what’s left in your budget after your monthly bills are paid.

These include credit card payments, car payments, child support, etc.

• Housing ratio (or "front-end ratio”): Lenders want your total mortgage debt (PITI) and condo fees to be no more than 30 percent of your gross monthly income; 28 percent is standard.

• Overall debt ratio (or "back-end ratio”): These are revolving monthly payments, such as Visa, MasterCard, car lease or loan payments, student loans, child support, alimony, monthly utilities. (They do not include those lattes, but you might want to plug in your lifestyle expenses for your own sake.) The ratio should not be more than 36 percent.

Debt-to-income ratio standards differ from lender to lender, and vary based on a loan program , but most lenders will give more weight to your credit history as a factor in determining your particular situation. Here is typical ratio for a first-time buyer:

Monthly gross household income: $5,700

Mortgage debt ratio: 28% $1,596.0

Expenses and overall debt: 36% $2,052.0

The mortgage debt of $1,596 is right in line with the current monthly rent payment in the example above. As long as the monthly debt obligations and household expenses are no higher than $2,000–2,300, this borrower should have no problem qualifying.

If your credit is stellar, you will be rewarded. Lenders may stretch these ratios to 38/45, allowing you to purchase more home and take advantage of more lending programs. And if you are a first-time home buyer applying for an FHA or VA loan, you may also be able to qualify with a higher back-end ratio — up to 41 percent of your monthly gross income — and get approved for these federally-insured loans.

How It Works

So, back to the question: How much home can I afford?

Keeping in mind the variables on debt-to-income ratios and the many lending programs available , here is a sample breakdown for a mid-range home. Note: The U.S. median home price is about $265,500.
Monthly gross household income (pre-tax): $7,000
Mortgage debt ratio 28% $1,960
Home price $350,000
20% down payment $70,000
Mortgage $280,000
Interest rate on 30-year mortgage 6.33%
Mortgage payment (principle and interest) $1,739

Here is an example of a lower price-range home, purchased with the same loan terms and interest rate:

Monthly gross household income (pre-tax): $3,600
Mortgage debt ratio 28% $1,008
Home price 150,000
10% down payment 15,000
Mortgage 135,000
Interest rate on 30-year mortgage 6.33%
Mortgage payment (P&I) $838

And the Other Costs …

In addition to the monthly mortgage payment, remember to factor in the added costs of home purchase and ownership. Since this buyer above did not put 20 percent down, he will need to add mortgage insurance, also known as PMI, to his monthly payment. Buyers also incur closing costs of 2.5 to 3 percent of the total loan amount. This covers the cost of title searches, appraisals, legal fees, etc.

So what’s left to apply to the down payment ? Using the example above, our first-time buyer has $15,000 for the down payment on a $150,000 home, and the closing costs may come to $4,500. The mortgage total just increased to $139,500. Over the 30-year loan period, this brings the mortgage payment to approximately $866 per month. If your head is not already spinning, now tack on mortgage insurance (fees vary based on the loan), homeowners' taxes and condo fees (if applicable), bringing the total monthly payment to approximately $1,038. The good news is this is still well in the range of the acceptable debt ratio.

Keep Some Money in Reserves

Many buyers invest every red cent they have into their new purchase, but it’s a good idea to keep some emergency cash, or "leaky faucet money," aside in the event of emergency repairs or a job loss. So don’t completely raid your savings; with home ownership, expect the unexpected.

Related links:Basic Mortgage Questions; Mortgage Pre-Approval; Coming Up With a Down Payment