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Know Your Home Affordability: For First-Time Home Buyers

This post is authored by James Paul.

How much home can I afford?

This would be the question cropping up in the minds of almost every first-time home buyers. The second most bothering question will be, "whom should I ask this?"

If you ask a mortgage lender, you might get the answer as "it depends". In general, there is no concrete figure to state your affordability for a home. Apart from the regular nervousness any first-time home buyer would undergo, the most bothering thing would be to know how much you can afford for a home.

Additionally, the fact is that the process to determine the home loan affordability differs from the way how you calculate it from the way any mortgage lender does. Most of us use a mortgage calculator to determine how much home you can afford. You might get a figure stating the affordable amount using a mortgage calculator and this would help you to decide on a budget for your home.

However, there are 2 ways to calculate how big your mortgage can be or how much you can afford on a home. The 2 ways would give you the insight of how any mortgage lender would determine your home affordability from the way you would determine it. Also, both the methods involve taking into consideration today’s mortgage rates to calculate the affordability for a mortgage.

Two ways to calculate your home affordability:

1. Create a budget to know how much you can afford
Let’s start with a more personal approach to know how much you can afford for a home:

A simple yet effective way to know how much you can afford on a home is to create a household budget. As a home buyer, you have the option of either fixing your own budget for a home or get the figures from any bank. In most cases, if you've good credit score then the bank would be more than willing to offer you a home loan that is far off your affordable limit. And on the other end, you might end up struggling with repayments plus the additional taxes taking over savings or any investments. The banks follow a strategy to give home loan based on your maximum home price so as to get more fees.

Next thing you would want to know is: "How to make a workable budget?"

Steps to evaluate a workable budget:
• First determine how much you can contribute every month towards the monthly payment for the home.
• Know what is the mortgage rate today
• Use a mortgage calculator to determine the loan size which you can afford with your monthly payments.
• With this approach you will have an estimate on how much you can afford on a home.

For instance, if you are planning for a monthly payment of $2,000 for a period of 30 year with interest rate of 4.25% then by doing a reverse math you can calculate the affordable amount for a home which comes to $390,030 for the mentioned monthly payment.

How much should you BUDGET for your own 'dream' home?

2. Ask the bank to determine your maximum purchase price
Another way to know how much you can afford on a home is to get the details from a bank for your maximum home purchase price. This maximum purchase price is calculated based on your annual income plus your annual debts. The banks use DTI (Debt to Income) ratio to calculate your maximum purchase price. The DTI is calculated in two ways:

• DTI using front-end ratio:
It is calculated based on: monthly principal + interest payments, monthly homeowners insurance due, monthly real estate taxes due and monthly dues due to an association. In general, lenders expect you to have a front-end DTI of 28% or less.

• DTI using back-end ratio
It is calculated based on: monthly housing payment(s), monthly minimum credit card payments, monthly car payments for a car loan or lease, monthly child support or alimony and monthly payments to an installment loan such as a timeshare. In general, lenders expect you to have a back-end DTI of 36% or less.

Generally, DTI of 45% is enforced by most conventional loans and others such as VA, FHA and USDA. The HomeReady™ program allows the maximum DTI up to 50% and on the other end jumbo mortgages allows DTI up to 40% only.

In short, the banks can only give you a figure of how much you "could" pay for a home; but not how much you "should" pay for a home.

Summing up:
The most essential criteria to determine how much you can afford for a home are today’s mortgage rates. As your monthly payments as well as your budget depends on mortgage rates. Thus, you need to keep a check on today’s mortgage rates in order to decide your monthly payment along with your budget.

Contributed by James Paul - a personal finance blogger who writes at Basic Finance Care covering everything about personal finance management and frugal living.

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