You may dream big when it comes to your first home. But living beyond your means may cause you to end up living to strictly pay your mortgage and not enjoying the little things in life.
Looking for a home can be a stressful time in your life. Where do you want to live? What features in a home are you looking for? How far from work do you want to live? How much can you afford to spend on mortgage payments?
The last question might cause the most stress. But luckily for you, this has been a question that people have been asking for years. Plenty of industry experts have weighed in and found great rules to follow to determine how much you can really afford to spend on a home.
Use the 28/36 Rule
Realtor.com introduces the 28/36 rule as a simple, yet affective guide for affordability. The 28 section refers to your monthly housing payments, including mortgage, insurance and taxes. These 3 items shouldn’t total more than 28% of your gross monthly income. It is easy to calculate, take your gross (pre-tax income) and multiply that by .28 or 28%. Let’s say your gross income per month is $5000, using this formula, your payments shouldn’t exceed $1400.00.
The 36 part of the equation refers to your debt-to-income ratio. That compares how much money you owe compared to your income. These items generally include credit card bills and student or vehicle loans. From our previous scenario, if your gross income is $5000 and your monthly debts total $550 you would divide $550 by $5000 and that would leave you with a debt-to-income ratio of 11%. Adding in the $1400 to your $550 in monthly debts would push your debt-to-income ratio to 39%, or just slightly above the 36 rule.
Based on these results, it would be a risky move to go ahead and purchase a home. Instead, you could spend a few months paying off your monthly debt or search for homes on the lower end of your affordability scale.
Talk to a mortgage lender and get pre-approval
Using methods like the 28/36 rule are great for pre-planning, but talking with a mortgage lender will get you officially pre-approved for a loan. Mortgage lenders will look at your personal financial history to determine how much money they will feel comfortable loaning you. This biggest benefit of the pre-approval process is that you look more attractive to home sellers as they know you have the financing to back you up.
To get pre-approved, there are a list of documents needed to be provided to a mortgage lender. Typically the list will include:
- Social security number for anyone on the loan
- Proof of employment is needed to validate income. Proof usually consists of your two most recent pay stubs
- Tax documents for the past 2 years is another way to help verify income
- Place of residence shows the lender your living situation for usually the past 2 years
- Bank account information lets the vendor know what your current financial situation is. They will want to see if you can cover items such as closing costs, down payment, and cash reserves.
- Credit information is needed to help determine your debt-to-income ratio
Depending on the situation a few other documents might be requested by your mortgage lender. If you have a family member who is going to help you, they might require a gift letter. The purpose is to ensure that it is truly a gift and repayment is not required.
A breakdown of your monthly expenses may be requested by a lender. This will help assure that you can afford a mortgage payment, especially if it shows that you have been consistently paying rent or your student loans.
You might have a situation where you own your business. Self-employment documents will be requested. Usually balance sheets, profit-and-loss statement, and federal tax statements from the past 2 years of business will be requested.
Know your number and plan accordingly
Whether you have used the 28/36 rule or have met with a mortgage lender and have been pre-approved, you should have your magic number in mind of what you can spend. Do some research on the areas you want to live and see what you can afford. Create a list of your wants then be prepared what options can be sacrificed to secure a home. Just because the home doesn’t have granite countertops, a sauna, and a wine cellar doesn’t mean you cannot potentially add these features later.
Once you get in the mindset of what you can afford, it will help you in your house hunting journey. Having big dreams regarding a potential home is fun, but waiting around for the absolute perfect home could take an eternity. While going to showings and open houses, you will know when the right home comes along. Be patient, think creatively, and visualize yourself living in a home before you purchase. You will be glad you did.