If you’re in the market for a new home or investment property, one of the first questions you’ll probably ask is, “What can we afford?” To answer this question, you must look at more than just the asking price of a home. You need to understand what your total buying power is, and the factors that will affect it.
Buying Power Defined
Since most people cannot pay cash for such a large purchase, your ability to borrow is an important part of your buying power. How much money do you have available each month after fixed bills and expenses for a mortgage payment? How big a risk are you as a borrower? Mortgage lenders will not only look at your credit scores, they will also consider your payment and employment history.
The available cash you have for a down payment is another piece that fits into the buying power equation. Once you take all of this into account, you may find you are able to buy a larger or more desirable home. You may also realize you should be looking for homes in a lower price range.
What About Housing Affordability?
Housing affordability is a metric used by real estate experts to assess whether or not the average family earning an average wage could qualify for a mortgage on the average home. Although this figure is essential to creating a comprehensive overview of the real estate market, it doesn’t define your buying power. What may be considered affordable to you based on your income and other factors will probably be different than what’s affordable to the average buyer.
Why Buying Power Matters
A common misunderstanding is that a home’s list price determines whether or not you can purchase it. Although it’s important to look at the price tag, it’s essential to consider what your monthly payment will be if you own the home. Two homes with the same asking price can have very different monthly payments. A home’s monthly cost will include annual property taxes, homeowners insurance, associated monthly fees, and any maintenance or repairs. Figuring out that monthly cost will prevent you from overestimating or underestimating your buying power. After all, you’ll live with your monthly payment, not the sales price.
Don’t forget to factor in your utility and transportation costs. Although these are not usually considered part of your monthly payment, they will affect the cost of owning a home.
Once you have clarity on your buying power, you’ll be able to buy the home you want, instead of settling for a home because you feel it’s the only one you can afford. It will also prevent you from becoming “house poor,” a common term for someone who’s put all their money toward the down payment or monthly costs, leaving them nothing left over for unplanned expenses and emergencies. Both scenarios can negatively impact the lifestyle you want to live. Understanding your buying power can help you get the home you want without sacrificing the lifestyle you desire.
Calculating Your Buying Power
You might be wondering, “How do I know what my buying power is?” Buying power is calculated by adding your down payment to the monthly payment amount you and your mortgage professional have determined you can spend for housing.
Your down payment could be from your savings and/or the money you made from selling your home (minus fees and mortgage payoff). The amount you will need to put down will vary quite a bit depending on what type of loan you are getting and how well you qualify for that loan.
If you haven’t sold your current home yet, a Comparative Market Assessment (CMA) will give you a general idea of how much you may get for your home based on what other homes have sold for in your area. Contact me for a FREE CMA!
How much you can spend on housing will come from all of your sources of income and investments that could be used to make your monthly payment. Make sure to include your monthly pay, commissions or tips, dividends from investments, payments from rental properties or other monthly income you receive.
Lender Guidelines
Most lenders advise buyers to spend no more than 35 to 40 percent of their pretax income on housing. Pretax income is all your income and sources of revenue prior to paying taxes. However, some financial experts advise spending no more than a very conservative 25 percent of your after-tax income on your housing expenses. Traditionally, mortgage lenders have targeted the ideal housing expense amount to be a ratio of 28 percent or less of your pretax earnings. When calculating your monthly housing cost, make sure you factor in not only your mortgage payment, but also property taxes, homeowners insurance, and typical homeowner fees.
Because housing in San Diego County, whether you rent or buy, is expensive, it is difficult to follow the strictest guidelines. Take a look at my Buyers’ Tips for more information about selecting a mortgage professional, calculating your monthly costs and purchasing a home.
These figures bring up an important point. You don’t have to spend all of your savings on your down payment. Moreover, you need to keep funds available for things like regular home maintenance and unexpected repairs.
While the above ratios are commonly accepted, a lender will look at your total financial picture when they decide how much they’re willing to lend. In fact, you should do the same. If you expect your income to rise and your expenses to stay similar to what they are, you might be able to spend a little more on a home. But if you’re planning on starting a family or starting your own business, you might want to take the more conservative path.
4 Things That Impact Buying Power
1. Credit score. A great score can help you lock into a lower interest rate.
2. Debt-to-income ratio. The lower the ratio, the better risk you may be to lenders as long as you have an established credit history.
3. Assets. This includes the documentation of where the money for the purchase is coming from and the mix of your investments.
4. Down payment. The more you’re able to put down, the less you will have to borrow. With a down payment of 20 percent or more, you won’t have to purchase private mortgage insurance (PMI), and you may also be able to negotiate a lower interest rate.
How to Save for a Down Payment
If you’re thinking of buying a home one day, one of the first steps to take is to start saving for a down payment. Here are some tips to make saving easier.
First-time buyers:
1. Set a savings goal. One way to figure out how much to save is to use the average sales price for homes that are similar to what you want and figure out your target down payment percentage. For example, if homes are selling for $500,000 in your area and you want to put 20 percent down, you’ll have to save $100,000. If that number is too daunting, you might look at loans that require less than 20 percent down or properties that sell for less, like condominiums and townhomes. Set a goal to save that amount within a specific time frame. Just keep in mind the longer you save, the more the average selling price will change.
2. Cut back on expenses. Review your monthly expenses and look for ways to save. According to the National Association of Realtors, twenty-nine percent of buyers cut spending on non-essentials items and 22 percent cut spending on entertainment while they were saving for a home. Think about items you can live without or cut back on temporarily while you’re saving.
3. Look for ways to boost your income. Get a side job or sell items online or at a garage sale to increase your income in a short amount of time. Be sure to save any windfalls you get, including your annual income tax refund or work bonuses.
4. Check out home-buying programs. Your state, county or local government may offer special programs, such as grants, for first-time and other buyers to use. For example, there are programs offered by San Diego County and some cities in the county, but funds are limited and you must meet certain requirements.
5. Ask your family. The National Association of Realtors’ statistics show that in 2016 thirteen percent of all buyers, and 24 percent of first-time buyers, were given money from family or friends to use toward the down payment of their home.
Repeat buyers:
More than 52 percent of repeat buyers used the proceeds from the sale of their primary residence toward the down payment on their next home. Similarly, 76 percent tapped into their savings accounts according to the same survey. If you’re thinking of buying another home, here are more ways to save more money, in addition to the tips listed above:
1. Rent a room. If you have an income flat (or mother-in-law unit) attached to your home and local ordinance allows it, rent it out and channel the income into a high-interest savings account.
2. Make your money work for you. If you don’t plan to buy for at least five years, invest it and let the compound interest work for you. Discuss this option with your financial planner or broker to see if this is ideal for you and your goals.
3. Tap into your 401(k). If you have a 401(k) plan, you may be allowed to borrow a portion of it, usually the lessor of up to $50,000 or half of its value, for your down payment. Remember, it’s a loan so you’ll have to pay it back. Additionally, if you leave or lose your job before you’ve repaid the loan, you’ll have between 60 to 90 days to repay the balance or face stiff taxes and penalties.
If you want to buy an investment property
Whether you’re buying a second home or a rental property, here are a couple tips to save for a down payment.
1. Tap into your equity. If you’ve paid off or paid down your mortgage on your primary home, you may be able to tap into your equity to purchase another property. Contact your lender to learn more about a HELOC or home equity loan.
2. Get a partner. Find a friend or relative who’s willing to purchase property with you. Typically, you’ll split the costs and profits. Before you purchase, make sure to work with an attorney to create a partnership agreement to fit your situation.
Work Out Your Buying Potential
What’s your buying potential? Fill out this worksheet to get an estimate.
| Housing Expense Ratio: | |
|---|---|
| 1. Monthly income before taxes | $ |
| 2. Multiply line 1 by 0.28 | X 0.28 |
| 3. Monthly housing costs consisting of principal, interest, taxes and insurance (PITI) should not exceed this amount | = $ |
| 4. Monthly income before taxes | $ |
| 5. Multiply line 4 by 0.36 | X 0.36 |
| 6. Total monthly payments on all debts (including PITI) should not exceed this amount | = $ |
| 7. Subtract the total monthly payments on all outstanding debts (e.g., car loans, credit cards, student loans, etc.) | – $ |
| 8. The monthly PITI should not exceed this amount | $ |
| 9. Look at line 3 and line 8. The lower figure is an estimate of the maximum housing payment in consideration of your income and debts. | $ |
Source: “Money Mechanics, Buying a House,” Iowa State University Extension, store.extension.iastate.edu/product/pm1460-pd
Monthly Payment on 30-Year Fixed Rate Mortgage
You can calculate your mortgage here to find out what your principal and interest payments would be. And if you’d like to find out your estimated monthly payment including property taxes and homeowners insurance, these calculators will do that for you.
Be Your Own Calculator
Use the table below to estimate your monthly payment (principal and interest only) per $1,000 of your loan. To figure out an estimated loan payment, multiply the factor by the number of thousands in the amount of your mortgage.
For example, if you intend to borrow $400,000, with a loan term of 30 years at 4% interest, multiply 4.77x 400 = $1908 per month.
| Interest Rate | 15-Year Term | 30-Year Term |
|---|---|---|
| Monthly Payment | Monthly Payment | |
| 3% | 6.90 | 4.21 |
| 3.5% | 7.14 | 4.49 |
| 4% | 7.39 | 4.77 |
| 4.5% | 7.64 | 5.06 |
| 5% | 7.90 | 5.36 |
| 5.5% | 8.18 | 5.68 |
| 6% | 8.44 | 6.00 |
Source: “Monthly Payment Per $1000 & Total Cost,” HSH.com, www.hsh.com/mopaytable-print.html
Factor in Property Taxes and Insurance
We usually look at the monthly house payment as the total of the principal and interest on the loan plus the monthly cost of property taxes and homeowners insurance. This is called PITI. If you are buying a condominium, townhome or many newer detached homes, you may also have homeowners or community fees that should be included with your PITI.
Mortgage professionals in San Diego County will usually use the California average property tax amount of 1.25% of the purchase price to estimate your annual property taxes. They will multiply the purchase price by 0.2% to estimate the annual homeowners insurance. Since these numbers vary, contact your county assessor’s office for the current property tax rate and your insurer for a home insurance quote. Once you have these figures, divide each by 12 to estimate how much they’ll add to the above payment amounts.
Do you want a clearer picture of your buying power? Would you like to see what kind of homes you can get with your buying power? Give me a call!