How Much House Can You Afford?
Understanding how much home you can realistically afford is one of the most fundamental rules of buying a home. Depending on your financial situation, your budget can determine anything from the neighborhoods to look at, to the overall size of the home, to even what type of financing you may qualify for.
Keep in mind that lenders will certainly look at more than just your base household income to understand the size of the loan you will need. A competent lender may also find some creative financing options that can help boost your purchasing power.
Loan Preapproval vs Prequalification : What's the Difference?
One of the best ways to determine your overall budget is to have your lender "prequalify" you for a loan.
Prequalification is very different from "preapproval", mainly because it is only a general estimate of how much you can afford. On the other hand, preapproval is a much more formal and detailed process where a lender examines your finances in much more depth and agrees (or not) in advance to loan you money up to a specified amount.
What Factors are Important to Lenders?
Banks and lending institutions use several criteria to determine how much they will finance for a particular loan situation. These can include:
- Gross monthly income
- Credit history
- Amount of your outstanding debts
- Savings--or the amount of money you have available for a down payment and closing costs
- Choice of mortgage (i.e. 30-year, FHA, etc.)
- Current interest rates
Two Important (and Mysterious?) Lending Ratios
Lenders also use your financial information to figure out two, very important ratios: the "debt-to-income ratio" and the "housing expense ratio".
Debt-to-Income Ratio (also called, "Let's Look at Your Bills!") Many lenders use this as a a rule of thumb" The amount of debt you are carrying each month (car payment, student loan, credit card, etc,) should not exceed more than 36 percent of your gross monthly income. FHA loans are slightly more lenient in their ratios.
Housing Expense ratio (also called, "Let's see How Much You Can Pay For A House Considering Your Current Income!")
It is generally difficult to obtain a loan if the mortgage payment will be more than 28 to 33 percent of your gross monthly income.
Down Payments Make A Big Difference
If you can make a large down payment, lenders tend to be more lenient with their qualifying ratios. For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.
Other Ways to Improve Your Buying Power
Gifts from Uncle Bill
If you're having trouble saving money, many lenders will allow you to use gift funds (for relatives, for example) for the down payment and closing costs. However, most lenders require a "gift letter" stating the gift does NOT have to be repaid, and will also require you to pay at least a portion of the down payment with your own cash funds.
Negotiating Closing Costs
Through negotiation, some sellers may agree to pay all or most of your closing costs (for example, if you agree to meet their full asking price). If you choose to try this, make sure to ask your real estate agent for advice.
Loan Programs from Uncle Sam
Many local governments have special loan programs designed to help first-time homebuyers. Loans may be available at reduced interest rates, or with little or no down payments. Check with your local housing authority for more information.
Some homebuyers choose Adjustable Rate Mortgages (ARMs) because of low initial interest rates. Others opt for 30-year loans because they have lower monthly payments than 15-year loans. There are significant differences between different loans, so make sure to discuss the pros and cons of different loans with your agent or lender before making a decision.