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If you’ve been thinking about buying a home in 2021, you are not alone. Due to the pandemic, there’s been a significant drop in the interest rate. As a result, many people are now shopping for new homes.
However, don’t let the lower interest rates make you oblivious to your financial realities; you’ll still need to calculate how much you can afford to spend on a home purchase. Even in a buyers market, it’s not wise to stretch your budget to the limit.
First, figure out how much of a down payment you have saved, and how much your monthly mortgage will be. As a renter, one parameter you can use is evaluating how much you are already spending on a monthly rent. Besides the down payment, buying a property includes closing costs like attorney’s fees, an application fee, and homeowners association fees. Also, it’s a good idea to have some money in your savings to handle unexpected emergency expenses.
If you are still unsure about how much you can afford to spend on buying a house, consider the 30% rule of thumb. It states that your mortgage should not exceed 30% of your monthly gross income, give or take 2%. When using the 30% rule to determine home affordability, you should also consider your other debts as well.
In addition, your debt-to-income ratio is another way to evaluate affordability. Most lenders consider this ratio before approving a loan. Let’s suppose your monthly mortgage payment is $2,000, and you have other debts, which also add up to $2,000 a month. Now your monthly debt obligation becomes $4,000. So, if you earn $12,000 a month, your debt-to-income ratio would be 33%.
A smart strategy includes setting a budget and sticking to it. Use the following tips to help you develop a budget:
When you first set your budget to prepare for a home purchase, look at your daily spending habits. If you are not sure where you are spending your hard-earned money, it will be a bit of a challenge to do any budgeting. Let alone know whether you can afford to buy a home.
To calculate all expenses, you can either use online tools or go the old-fashioned route and make a spreadsheet where you can write down all your expenses.
Start with credit card bills and get a fair idea of where your money is going. Next, jot down other expenses like utility bills, car payments, or other payments which are not made using a credit card. These could include paying a babysitter or dog walker in cash or leaving a few dollars as a tip at a restaurant. Make sure you evaluate at least six months’ worth of expenses to get a clear picture of your average expenses.
It is pretty normal to spend money on things you don’t need. But you may not be able to do that any longer if you plan on buying a home within your budget. Review the spreadsheet you made and look at the expenses that can be eliminated, like unsubscribing to services you only had because you didn’t have time to do them yourself. Every dollar counts, so cut down whatever expenses you can.
Now you need to estimate the monthly mortgage payment. You can use online calculators. All you need to do is enter values like a realistic home price, the down payment you have saved or you think you can pay, the length of the loan, and the current interest rate. Unfortunately, though, the interest rate keeps changing, and it may be lower or higher by the time you are ready to purchase. For now, put in the current realistic value. If you need more accurate results, put in the estimated property tax and home insurance tax as well.
Take the resulting amount and subtract the current monthly rent you pay. This is the amount you should put in the bank for your down payment or closing costs. Repeat this exercise every month until you are ready to buy a home, and those savings will go into down payment or closing costs.
Once you know how much you will need to spend on a monthly mortgage, set up a new account for home savings. You should not touch that money–it should only be used to buy a home. It is even better to set up an automatic transfer at the bank to that savings account of funds to that account. So you don’t have to think about moving the money. It also helps eliminate any temptation you may have of pinching off money from your savings to spend on other things.
A credit score is critical to getting approved for a mortgage. Start by getting a copy of your latest credit report. It will tell you your credit score based on the number of outstanding debts you have and your payment history. Look at the report thoroughly and correct any errors you might see. Pay down your debts to improve your credit score.
Buying a home is still the American dream, but it can quickly turn into a nightmare if you choose to spend more than you should. Unfortunately, people who buy their first home often make this mistake. They look for a dream home and end up spending more than what they can handle.
On the contrary, future homeowners should make sure they can afford the house they’re buying and still meet their other monthly obligations. Without proper budgeting, they may end up in a financial catastrophe.
So, before you hit the market to hunt for your dream home, take some time to do a little budgeting. Which should include how much you saved for a down payment. How much you can afford in monthly mortgage payments, the market value of the home, taxes, closing costs, and the interest rate.