Buying a new home is exciting, but ideally it also should give a feeling of stability and financial security. What you do not want when you buy a house is to barely have enough money each month to meet your financial obligations. That is why it is very critical to know how much house you can afford before you ever get in the car to scout out neighborhoods. To stay away from the living nightmare of having a house that you cannot afford to pay the electric bill, you have to determine a housing budget that works for you. As you are determining the size of mortgage you can afford, one tool to use, experts say, is the 36% rule.
According to this guideline, your total debt payments every month should not be more than 36% of your gross monthly income. So, for every pre-tax dollar you make each month, no more than .36 of that dollar should do to pay for:
Of course, the 36% rule is more a rule of thumb than a super strict rule, but most mortgage lenders raise their eyebrow at potential buyers with debt to income ratios higher than 36%. The risk of foreclosure rises substantially at that point. It is possible to locate mortgage lenders who will lend at higher ratios, but you will pay a higher interest rate. However, most experts do not recommend paying more than 36% of your pre-tax income towards debt. The reason is that if you are spending that much money every month on your pre-existing debt obligations, just a minor financial hit – such as a new roof or a blown engine in your car – can make it impossible to pay your mortgage. Banks are wary of lending to people with a low margin of error. So, your pre-existing debt is really important to determine how much home you can afford.
Also remember that lenders will charge higher rates to people who have a debt to income ratio above 36%. This will cause you to pay higher interest every month. And, the difference between a home that takes 35% of your monthly income and one that takes 45% is a nice chunk of change.
While it may not sound like a huge amount of money, that additional 10% of income could be a big deal if there is a change in your financial situation. Say you are no longer able to get overtime, or gas prices spike (remember 2007 and 2008 when gas was nearly $4 per gallon?). It always is nice to have some financial cushion for when things go sideways. And if you live long enough, you will spend a good portion of your life dealing with unforeseen financial difficulties.
Another critical factor in how much home you can afford is your down payment. The larger your down payment the lower your rate, and usually, the bigger the house. But lenders today want to know that you have cash reserves so you can pay the mortgage if you lose your job. So, you and the bank really want to know not just if you can afford the home on your current income, but that you can afford it if there is an unforeseen financial problem next year. Having several months of cash reserves in the bank is a good way to protect yourself from a major financial problem. Experts say that you should have at least three months of mortgage payments in the bank, but six months is even better. Let's say you lose your job next week. Wouldn't you feel better knowing you have six mortgage payments in the bank? It can take more than a month or two to find a new job.
When it comes to how much home you can afford, you must carefully consider your monthly budget. Make sure that you do not go over 36% of your monthly pre-tax income. Even if the bank will give you a loan at the higher debt to income ratio, that could lead to a great deal of financial stress when you least want it. Buying a home that is well within your means, as opposed to one you can barely afford, will give you much more peace of mind.
There are many examples out there of people who bought as much home as they can afford, and they cannot afford the utility payments or to buy furniture. What good is a big, fancy house if the electric bill goes unpaid and you have rooms with no furniture in them?
Just be realistic about your monthly budget and buy a home that fits well within your budget, even if there is a financial emergency.
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