November 9, 2020
For many, owning a home is the American dream. Some who envision themselves in their own home are looking at years’ worth of savings and preparation to make that dream a reality; others may be surprised that they can already afford to buy a home. In general, most people will need to do research and some additional work to get their finances or income lined up with the cost of home ownership. The answers to some key questions can help you answer the larger question of whether you’re financially ready to buy a home.
What Is a Home Affordability Calculator?
When you kick off the home-buying journey, lenders will look at a variety of factors to understand how ready you are to purchase a home, and that you are ready to make the required monthly payments. Before getting too deep into the process, make sure that you have a general understanding of what you can afford. A great place to start is by using a home affordability calculator with your financial particulars as inputs.
The PenFed home affordability calculator asks you to input your annual income. You can use combined income if purchasing with a co-buyer or spouse. It also asks for your ongoing monthly debts. You'll need to account for car payments, credit card payments, and home equity or other loans you may have to get a handle on your overall debt. You'll also need to enter a projected down payment, as well as the term of your loan. The term is the length of the loan; typical terms are 15, 20, and 30.
We entered the following into the PenFed calculator:
- Assumed an annual salary of $75,000
- Monthly debts of $1,000
- Down payment of $10,000
- A term of 30 years.
The output is something you can manipulate in terms of how aggressive a loan you want to take. The mid-range output, using the above assumptions, indicates that a home costing $294,000 is within reach in the above scenario.
If we keep the annual salary and the monthly debt the same, but reduce the down payment to $5,000, with a 30-year term, the total displayed drops to $289,000. This gives you an idea of how you can play with the inputs and see how modifications to the numbers can change the projected amount that you can afford.
This sort of calculator is a great way to begin your research and may help you realize that buying a home might be within your financial reach even sooner than you think. However, there are a lot of variables that go into the final home buying and approval equation. Next, we'll review some key considerations you should factor in.
How Important Is My Credit Score When Buying a Home?
Notice that credit score wasn't part of the equation when we used the affordability calculator with the above financials. However, you really can't get a mortgage without a good understanding of what your credit score is, and ultimately how important that may be for obtaining your loan. Assume two different people have the exact assumptions laid out above for salary, monthly debts, and down payment. If one person has a great credit score, and another has a terrible credit score, the person with the terrible credit score might need to improve their credit before obtaining approval for a mortgage loan.
There are many ways to improve your credit score if you need to, and it's always good to stay on top of what the credit agencies are reporting about your credit, regardless of the competitiveness of your score. It's not uncommon for there to be errors in the agencies’ reporting, and it's ultimately your responsibility to ensure the reporting data is correct. Understanding your credit score and creditworthiness is something you should embark upon early in your home buying process. This will allow you to make corrections and improve your score over time, should you need to.
How Does Debt to Income Ratio (DTI) Affect My Homebuying Power?
DTI is used by lenders to better understand your ability to afford a home. If you're looking to buy a home, it's a good idea to pay off as much debt as possible before applying for a mortgage. Not only will this improve your credit score, but it will also reduce your DTI. Monthly expenses like gym memberships, utilities, and even insurance are not included in DTI calculations. Be aware that most lenders will not even consider anyone with a DTI higher than 43%.
How to calculate DTI:
- Add up your monthly expenses, including car payment, credit card(s), rent, and school loans. Let's pretend as an example the amount comes to $1,500 total.
- Assume $5,000 monthly income (before taxes) for this example.
- Your DTI is your expenses ($1,500) divided by your gross income ($5,000) = $1500/$5000 = .3 or 30%. 30% is a good DTI.
How Much of a Down Payment Do I Need to Buy a Home?
The amount of down payment you need depends on several factors. One is the type of mortgage loan you get. For example, if you are eligible and apply for a VA loan, you might not need a down payment at all. Some other loan types require 3-5% as a minimum. Typical guidelines recommend 20% as your target down payment.
Down payment — as we saw in the home affordability calculator — can come into play in the overall purchase process in several ways. First, if you put less than 20% down on most loans — excluding a VA loan — you'll need some type of mortgage insurance. This is a monthly fee, usually paid with your mortgage, that protects the lender. Another way a down payment can factor in is if you are placing a lot of money down. While not as common, having a large percentage of the home price as a down payment reduces the risk for the lender, which makes the buyer more a more attractive candidate for a loan.
How Important Are Interest Rates in Determining What I Can Afford?
Mortgage interest rates fluctuate over time with the market. In the 1980s, interest rates were well over 10%. In recent years, interest rates have been around 3% and even lower. There are ways to reduce your interest rate via different loan types, such as adjustable rate mortgages (ARMs). Another way to reduce your interest rate is to pay "points" at closing. A point is 1% of the total loan. Paying points at closing can help you reduce your overall rate for the length of the loan.
The biggest takeaway is that taking a serious look at your finances and starting to prepare when you first thinking about buying a home can help you to understand all of your options and get the best loan for the home that fits your lifestyle and financial situation. You might find that need to spend some more time getting your finances in order, or you might learn that you are ready to buy now.