|Gary Foreman is a former Certified Financial Planner (CFP) who currently writes
about family finances and edits
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Can you help me? My husband and I would like to buy our own home to
live in. How do we know if we can afford one or not? Thanks,
Donna's smart! It's always better to
find out if you can afford something before you begin seriously
shopping. And with low mortgage rates and home prices going up, many
people are wondering if they should buy their first home now.
So how does Donna determine if they
can afford to buy? Answers to a couple of questions can help them
decide. First, do they have enough savings to get into a home?
Second, can they afford the regular, ongoing monthly expenses.
Let's begin with the first question.
How much would it take for them to get into a home? Affording a home
means more than having enough cash for a down-payment. Initially
Donna will need enough savings to cover a down-payment, the closing
costs and some initial expenses like utility deposits.
She'll also need some cash for some
of the expenses that come with a first home. Things like a
lawnmower, ladder and basic lawn implements. Homecenters love
Naturally, the down-payment is the
biggest item. It usually runs from 5% to 20% of the price of the
home. You can even find some deals with 100% financing, but Donna
can expect to pay higher interest rate if her down-payment is lower.
She probably should plan for about 10%.
Many mortgages have fees or
"points" associated with them. It's not unusual for that
to add 2% to the amount that she'd need at closing.
Closing costs vary by locale and by
what you negotiate in the contract. She can use 3% as a guesstimate,
but that could be off by as much as 2% depending on the
circumstances of her contract. Some places customarily allocate more
expenses to the buyer than other places. Donna should ask someone in
the real estate industry what costs are typically paid by the buyer
in her area.
A few quick calls to the utility
companies should give Donna an idea of any deposits or set-up
charges that will be required.
Once Donna has determined if they
have enough money to get into a house, she'll need to figure out if
they can afford to hang onto it.
Most experts say that housing
expenses shouldn't exceed 35% of your after-tax, spendable income.
Donna can calculate her annual after tax income using her payroll
check information. In fact, unless she got a large IRS refund or had
to write a large check last April, she probably can use the net
figure from her paycheck. All she needs to do is to figure out how
many paychecks she'll get in a year and then multiply her after-tax
pay by that number.
Another benchmark that some advisers
use is to total all debts and then compare that to income. The
reason is simple. The part of her paycheck that Donna has already
committed to car payments or credit card minimums is not available
to pay the mortgage. Typically experts suggest keeping total debt
payments to less than 40% of Donna's income. If her estimate of a
mortgage added to her existing payments exceeds 40%, she might be
wise to try to pay down some debt before she begins house hunting.
There's another more accurate way to
gauge Donna's ability to handle the monthly expenses. That's to
create a "make believe" budget that included a house
payment. She would take her current budget and just replace her
renter's expenses with the mortgage payment and other homeowner's
expenses. Don't forget to include taxes, insurance and some money
each month for home repairs.
If Donna is close but can't quite get
the numbers to work, she could check out some lower cost
alternatives. Foreclosures or "handyman's specials" could
offer an opportunity. She might also want to consider buying a
duplex and renting one side while living in the other.
Finally, if she does decide to buy,
Donna will want to check her credit report before she begins
shopping. That will give her an idea of how she'll look to a
mortgage company. A FICO score of over 700 should put her in good
shape. She'll be able to find a mortgage with a score in the 600's
or even 500's, but the interest rate will be higher.
She should also check her credit
report for errors. About 25% of all credit reports contain an error
significant enough to effect the interest rate on a mortgage. If
Donna finds an error she'll want to get it corrected before she
begins shopping for a home or a mortgage.