Can You Afford to Buy a Home?

Row of housesBefore deciding to buy a home, it's important to review the short-term and longer-term financial implications of such a large purchase. If you're making this decision with anyone else, be sure to address the financial implications with them as well.

Below are some matters to consider.

How large a mortgage can you afford?
Once you feel you might be ready to buy a home, do some exploring around neighborhoods you might like to live in and find out how much homes are selling for. You can do this investigating on your own or with the help of a real estate agent. Then, to get a sense of whether buying a good property in a good neighborhood is a realistic short-term goal for you, take a new look at your current budget and crunch some numbers to figure out if you can afford the montly payment. Remember to factor in the taxes and insurance.

Adjustable rate mortgage (ARM): a home loan with an interest rate that can change periodically in relation to a given benchmark. With an ARM, when the interest rate changes, your monthly payment goes up or down accordingly.

Fixed-rate mortgage: a home loan with a fixed interest rate and fixed payment amount lasting the full term of the loan.

Points: prepaid interest charged by a mortgage lender. Each point equals 1% of the loan amount.

Private mortgage insurance (PMI): an insurance policy that protects a mortgage lender against loss in the event the borrower defaults on the loan.

Generally, your gross (before-tax) monthly housing costs, comprised of your mortgage payment (both principal and interest) property taxes and homeowners insurance premiums, should not exceed 28% of your gross monthly income. Also, typically, your gross monthly housing costs plus total monthly payments on items such as car loans, credit cards and other debts should not exceed 35%. If you're projected to exceed such thresholds, lenders may not approve you for a mortgage out of concern that it would jeopardize your financial stability. Consider going online and using one of the many calculators available for getting a general idea of how large a mortgage payment you can afford.

The type of mortgage you end up getting will play a big role in the amount and affordability of your monthly payment. There are two basic types of mortgage – fixed rate and adjustable rate – and there are many variations within each category. A fixed-rate mortgage offers a steady interest rate and a steady monthly payment. With an adjustable rate mortgage or ARM, the interest rate, and, therefore, your monthly payment, can change periodically – for example, every year or two. The lender bases the ARM's interest rate on a predetermined benchmark, such as the rate being paid on U.S. Treasury securities, and then adds a margin of around 2% to 3%. If you're likely to own your home more than a few years, you might like the predictability of a fixed-rate mortgage.

However, if you plan to sell the home before an adjustable rate has had the chance to increase by much, or if you think rates will fall over time, an ARM might be your preferred option.

How much cash can you put down?
Typically, lenders will require that you make a cash down payment of up to20% of the home's price up front in order to secure a mortgage. In some cases, lenders may grant a mortgage to a qualifying homebuyer with a down payment of as little as 3% of the purchase price (in certain areas). However, if you put less than 20% down, most lenders will require that you buy private mortgage insurance, which protects the lender in the event you default on the loan. Plan to put down as much as you can, but try to keep enough cash on hand to cover things like moving expenses, furnishings for the new home and any repairs or remodeling you might want to do. You will also need to be able to cover all closing costs required by the lender, as explained in the next section, plus property taxes, pro-rated portion of the first month's interest, and other fees. Remember the importance of having an emergency fund of three to six months’ worth of living expenses in the event of a financial hardship.

Can you afford the closing costs?
When you close on a home – that is, the day you sign papers to take ownership of the property – the lender will require you to pay a set of fees known as closing costs. Your closing costs may include one or more mortgage “points,” which are basically prepaid interest charged by the lender in return for the interest rate they have agreed to charge you for the loan. Each point equals 1% of the loan amount. For example, on a $150,000 loan, one point equals $1,500.  Other closing costs may include fees for loan processing, the loan application, credit reports, an appraisal on the home, title insurance, surveys and the lender's attorney. Your total closing costs will typically add up to between 2% and 7% of the value of the property you're purchasing.

What might the costs and benefits be further down the road?

As a homeowner, you will need to budget for ongoing maintenance of the property. Although your home may appreciate in value, there is also a chance you will lose money on your investment if the property depreciates in a declining housing market and you sell before the market swings back upward.

Owning a home can also yield financial rewards, including tax benefits. For example, as a homeowner, you will generally be able to deduct any points and mortgage interest you pay to the extent that the amount of your mortgage does not exceed $1 million. You will also be able to deduct property tax payments (but keep in mind you should always consult your tax advisor or an accountant before making any such decisions, to ensure these items apply to you and your new home and are in accordance with applicable tax laws).

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