If you’re in the early stages of planning to buy your first home, you probably have a lot of questions about what it will all cost and how much you can afford. If you’ve already gotten a mortgage prequalification or preapproval, you may think your lender has already done this for you. But your lender only knows a tiny bit about you, and only you can make realistic decisions about your spending priorities.
How To Build Your Home Buying Budget
The first thing you need to do is sit down and develop a budget. There are some general guidelines out there to help you get started.
Use The 28% Rule As A Starting Point
This rule suggests that your housing budget should be 28% of your gross income. Remember that this is just a rule of thumb, and it’s as good a place as any to start thinking about how much you should spend on your home. But if you live in one of the many high-price U.S. real estate markets, it’s a tough one to adhere to.
Know Your Debt-To-Income Ratio (DTI)
Another way to help plan your budget is to consider your DTI ratio. That’s the percentage of your gross monthly income that’s spent on monthly debt payments. Lenders will consider your existing monthly debt as well as your future monthly mortgage payment in this calculation. DTI is an important indicator of whether you’ll be able to make your monthly payments over the life of the mortgage.
It’s a good idea to figure out your DTI before you apply for a mortgage preapproval, because it will be an important factor in determining whether you’ll be approved and what rate you’ll pay.
What does all this mean? In general, lenders like to see applicants with a DTI around 36%. That means for every $100 you earn, $36 goes to pay your monthly debts. Having a higher DTI ratio doesn’t mean you won’t get approved, but you may not qualify for the lowest available mortgage rates.
Develop A Down Payment Strategy That’s Right For You
Traditional down payments are 20% of the purchase price of the home. However, there’s no actual rule that you need a 20% down payment. Having a 20% down payment has been considered the gold standard, because when you have 20% equity in your home, you don’t have to pay for private mortgage insurance, or PMI.
But if you’re renting in an area with a high cost of living, it can seem impossible to save enough to reach 20% of anything available. A counterargument to the 20% down payment rule is that, instead of paying rent until you save a full 20% down, you could buy with a smaller down payment and start making mortgage payments now, albeit at an additional cost due to PMI, and build up to 20% equity (at which point PMI is no longer charged).
Because saving up for a down payment can be such an obstacle to home ownership, the Federal Housing Administration, or FHA, offers low down payment mortgages, as do government-sponsored enterprises Fannie Mae and Freddie Mac. In addition, the VA offers no down payment loans to qualified aspiring homeowners.
Upfront Costs Aside From The Down Payment
But how can you develop a budget if you don’t know all the costs? We’re here to help you work through this chicken-or-egg dilemma.
Don’t forget the closing costs! Aside from a down payment, closing costs average 3 – 6% of your home’s purchase price. There are some no-closing-cost mortgages available, which roll the closing costs into the mortgage. But if you choose one of those, you’ll end up paying interest on the closing costs as well as the loan principal amount.
Costs Of Home Ownership
When budgeting for your home, don’t forget that there are additional costs to the mortgage. You’ll have to pay property taxes, homeowners insurance and, if you join one, homeowners or condo association fees.
You can use our mortgage calculator to figure out those additional costs. Most lenders require you to pay them on a monthly basis along with your mortgage payment, and then collect it in an escrow account to ensure they are paid on time.
If you live in a city and you’re moving to a suburb, you’ll have to factor in costs for things like lawn mowers and barbeque grills. You’ll also be paying more for things like heating and cooling your larger space, and you’ll incur extra transportation costs if you’ll be commuting.
Other Things To Consider When Budgeting For Your Home
You want to own a house. You don’t want your house to own you. Here’s where soul-searching meets budget planning.
Think about your lifestyle and your daily pleasures. By all means, cut the mindless spending. But remember that budgets should reflect your spending priorities so you don’t end up busting your budget sooner, rather than later. So, think about what’s important to you, write it all down, attach a realistic price to it and add it to your budget.
During the pandemic, you may also have been debating whether you need to stay in an urban center or close suburb with the rise of remote work. If you’re committed to city living, you might be able to find some relative bargains as working from home means city dwellers are no longer constrained by work obligations.
Give some thought to whether you want to buy a starter home versus a forever home. Starter homes tend to be built during the earlier waves of suburban development, but could include condos. Because they tend to be closer and smaller than what most of us think of as forever homes, they cost less to heat and maintain, assuming there are no problems discovered during the home inspection process.
Unless you’re very handy, though, don’t take on a home that requires substantial renovation, no matter how tempting a “bargain” it may seem. Nothing busts a budget faster than living in a money pit.
You Decide What You Want To Afford
Buying a home is a huge financial decision that you, and only you, can make. Make sure it’s the right one. Once you have a realistic idea of what you want, you can look forward to an affordable future in your new home. Learn more about the first-time home buyer’s journey in our Learning Center.