Sociologists often divide people into two groups when it comes to money: spenders and savers. But there’s another important distinction those experts often ignore: people who carefully plan their spending, and those who don’t bother.
Setting a budget – and keeping to it – is a great way to reduce stress. When you’re ready to make an offer on your dream home, however, it’s virtually a necessity.
First of all, you really have to know how much house you can afford, before taking on a huge mortgage payment for the next thirty years. Just as importantly, you’re going to have to prove to a bank or other mortgage lender that you can actually afford that loan – and that you’re going to be able to pay it back.
So even if you’re not naturally included to make budgets it’s time to start if you’re serious about homeownership.
Here’s how to do it.
Your Personal Budget
It’s tempting to start by trying to figure out exactly what your new house is going to cost you. Don’t do it that way. The first thing you need to know is exactly how much you have available to spend on a new home. The way to do that is to calculate your personal monthly budget, to get a clear idea of how much you spend on everything else – and what would be left to spend on a house.
This total should reflect your household’s total monthly net income. Don’t use your gross monthly income in calculations, because you can’t spend (or save) the money that your employer deducts from your paycheck.
- Start with your regular monthly take-home pay.
- Add the regular monthly income earned by everyone else (like your spouse) who contributes to the family’s expenses.
- Include any additional regular part-time or freelance income; mortgage lenders may not use that extra money to compute your creditworthiness, but it definitely matters when you’re figuring out your personal budget.
- Include any other regular monthly income such as social security payments or alimony payments.
Make a total of all your regular monthly expenses, not counting your housing expenses. We’ll get to those later.
This list should include items like:
- Health insurance and medical costs not paid by your employer
- Gas, electricity and other utility bills (these may change when you buy a house, but you can use current numbers for now)
- Transportation (car payments, gasoline, train or bus fare, etc.)
- Student loan payments
- Credit card and other monthly debt payments
- Personal items and recreation costs (everything from bathroom soap and toothpaste, to your morning Starbucks stop and nights out with friends)
- Charitable contributions
- Monthly after-tax contributions to investment or savings accounts
Take your total monthly expenses, and subtract them from the total monthly net income you calculated in the last section.
Total monthly income: $6,000
Total monthly expenses:$3,600
Available for housing: $2,400
That’s a very important step, but you’re not done. $2,400 isn’t what you can afford for a monthly mortgage payment – there’s more work to do before we have that final number.
Your Housing Budget
When buying their first home, many people don’t realize the hidden costs of home ownership. First-time buyers often leave themselves cash poor, because they only included their monthly mortgage payment in their housing budget.
Let’s start with the monthly payment you’ll be making to the bank or mortgage company every month. In most cases, it isn’t only the actual amount you owe on your home loan; it includes four (or fewer) components.
- Loan payment (loan principal and interest)
- Property taxes
- Homeowners insurance – Monthly premiums are often, but not always, included
- Private mortgage insurance (PMI) – Charged to borrowers with small down payments or low credit scores
That number is an important starting point, and you can estimate it by using one of the many online mortgage calculators available at lenders’ websites and other real estate sites like Zillow.
The calculators allow you to change the variables so you can estimate your monthly payments based on different home purchase prices, mortgage interest rates, down payments and property tax rates. You can search online to find ballpark numbers to use for interest rates and tax rates, or you can ask your realtor (if you have one).
To understand how much your mortgage payment will change when you go up or down on purchase prices or mortgage rates, run the numbers several times using different assumptions each time.
That will give you several more numbers you can use in your budgeting. To make things simple for this example, we’ll assume that only your purchase price changes (not the mortgage rate or taxes). You may get numbers like this:
$200,000 home: $1,200 monthly payment
$250,000 home: $1,400 monthly payment
$300,000 home: $1,650 monthly payment
We’re not done yet, though.
“Hidden” items to add to your housing budget include:
- Annual homeowners’ insurance premium (if it’s not included in your monthly payment): The first year’s premium is normally paid upfront, at the same time as closing costs.)
- Maintenance: You’ll either have to buy a lawnmower or pay someone to mow the lawn, furnace filters and light bulbs will have to be replaced regularly, paint doesn’t last forever, and you may need to contract with a pest control service or alarm company. Regular costs like lawn maintenance or pest control services should be estimated as best as possible. Smaller ones can be bundled into your emergency fund.
- Emergency fund: A new home doesn’t come with lifetime guarantees; the water heater could explode or the roof could start leaking. You should save money each month, to be used for repairs and other unexpected problems.
Good rules of thumb:
- Save 1% of the home’s purchase price each year (for example, $2,000 per year, or $166 per month, for a $200,000 home).
- Save $1 per square foot each year ($2,000 per year or $166 per month, for a 2,000 square foot home).
- Save for HOA (Homeowners Association) fees, if applicable.
- If you live in an area where bad weather can do a lot of damage to your home, if your home is in less-than optimal condition, or if it’s more than 10-15 years old, increase those annual contributions by 10% for each factor each year.
- If you know your utility payments will change drastically (for instance, if you’ll be moving from a two-bedroom apartment without air conditioning, to a 2500 square foot air conditioned home), you should add that extra amount into your housing budget as well.
Whew! That’s it.
Add your monthly payment and the other hidden costs we’ve mentioned, and compare that total to the number you came up with as “available for housing.” That will show you whether you’re in good shape.
For example, let’s assume you want to buy a 15-year old $200,000 home, which would require a $1,200 monthly payment.
To make things simple, we’ll also assume that homeowners insurance is included in your monthly mortgage payment, you don’t have to pay HOA dues, and you won’t have to make additional monthly maintenance payments.
We’ll include maintenance costs in your emergency fund. That starts at $166 per month and has to be increased by 10% to $182 per month, because you’re buying a 15-year old house. Finally, we’ll assume that your home utility payments will be $200 more than you’re paying in an apartment.
Looking at the numbers we’ve come up with:
Available for housing: $2,400 per month
Housing costs: $1,200 monthly payment
$ 182 per month for emergency/maintenance
$ 200 per month additional for utilities
Total monthly costs: $1,582 per month
Congratulations! You have much more than you need available each month to buy that $200,000 home. In fact, you have enough to start looking in higher price ranges.
Your Numbers Won’t Be the Same as Your Lender’s
One final caution: just because your budget shows that you can afford the home of your dreams, that doesn’t mean your lender will automatically agree.
Banks and mortgage companies use different formulas to decide on a home’s affordability for your income level and financial situation. They’ll look closely at your credit score (there are different qualifying levels for conventional, FHA, VA and FHA loans), your full credit report, your debt-to-income ratio (how much you owe vs. how much you make), and a number of other pieces of documentation.
But by putting together your housing budget, you’ve taken the important first step in the home buying process: being able to shop for a house, without having to worry about whether you can afford it.
Do you have other concerns about buying a house? Check out our complete guide to the questions you should ask before purchasing a home.