By Eric Rosenberg, WCI Contributor
Whether you’re ready to make a jump from renting to owning your own home for the first time or you just want to upgrade (or downsize) to something new, one of the first questions most people ask themselves is: “How much house can I afford?” Knowing your home-buying budget is critical when making one of the biggest financial transactions of your life.
Here’s a look at the most common expenses to expect when buying a home and how you can translate your income and current debt load into a guideline for how much you can spend on a house. Keep reading to learn more.
What Factors Help Determine How Much House You Can Afford?
The first step in buying a home is knowing what you can afford. Banks and other mortgage lenders look at your income, outstanding debt obligations, and credit history as the most important factors when approving your loan application.
Tip: It’s a good idea to get preapproved for a home loan before you start shopping, particularly in competitive real estate markets. Preapproval involves a full review of your credit and a conditional offer for a loan, assuming you find an approved property. Prequalification, which is a less rigorous process, is not the same thing as preapproval.
Debt-to-Income Ratio
Your debt-to-income ratio (DTI) compares your income to your debt obligations. Lenders use this as a guideline to decide if you can afford a home. Using your estimated debt-to-income ratio after the purchase, your banker can help you calculate the maximum home loan for which you would qualify. When added to your down payment savings, that’s roughly what you can afford to spend on a home.
As a doctor with medical school loans, your DTI ratio may not be a simple rubber-stamp, even with a high income. If you want to run the numbers and calculate your DTI ratio, here are the steps to follow:
- Get a copy of your credit reports: Start by going to AnnualCreditReport.com—the government-mandated website to get your free credit reports, and get a copy from each of the three major credit reporting bureaus.
- Add up your monthly payment obligations: Next, go through your credit reports and add up the minimum monthly payment listed for each credit card, student loan, auto loan, and any other loan payments. Also, include any court-ordered payments like child support or alimony. You may not have to include accounts where you’re an authorized user, like a parent’s credit card you have for emergencies. If you’re applying with a spouse, include any monthly payments listed on their credit reports as well.
- Find your total annual income: Next, get your most recent paystub, which is used as proof of income by your lender, and multiply by your number of monthly pay periods to get your annual gross income. Hopefully, that number matches what you expect. Again, if you’re applying with a co-applicant, add their income, too. Lenders will also ask for a copy of your latest W-2 (or two) as evidence of income.
- Enter your numbers into the debt-to-income ratio formula: Finally, take your total monthly debt payments and divide by your gross monthly income–that’s income before deductions. Here’s a simple form from the Consumer Financial Protection Bureau (CFPB) that can help you understand the math:
According to the CFPB, most lenders require a DTI ratio of 36% or less. Some will lend up to 43%. As a renter, it’s best to aim for a DTI of around 15%-20% or less. The agency also advises keeping your mortgage debt to less than 35% of your income.
Credit Score and Report
You’re not done with your credit report just yet. Just because your income says you can afford a home doesn’t mean you are guaranteed a loan. Lenders also review your credit report for a history of late and missed payments alongside your credit score to determine your creditworthiness.
Using the same credit report from your DTI calculation, you can look for any reported late or missed payments. Bankruptcies, court judgments, and charged-off accounts are more severe than a slightly late payment. But a pattern of late payments may prevent you from getting a mortgage at all.
If you want to see your credit score too, you may find that information from your current credit card company websites. You can also use free credit score websites like Credit Karma or Credit Sesame. Every lender has its own minimum requirements for a mortgage. For government-backed FHA loans, the absolute minimum credit score is 500, though you’ll need a score of 580 or above to qualify for the low 3.5% down payment program.
Understand All Costs of Buying and Owning a Home
Don’t rush to buy that home just yet. Many homeowners find themselves in the position of being “house poor,” where expenses added up more than they realized ahead of time and put them into a financial crunch. Rather than buy the most expensive home you can get your hands on, add up your estimated monthly expenses first to ensure you truly can stay on top of your future mortgage payments and other homeowner expenses without going broke in the process.
Closing Costs
Closing costs when buying a home typically add up to around 3%-5% of the home’s price. If you’re buying a $500,000 home, for example, closing costs would be approximately $15,000-$25,000. That has to be paid at closing or included in your mortgage. Common costs include appraisal fees, tax service fees, title insurance, taxes, prepaid expenses, and real estate agent fees.
Property Tax
Property taxes vary widely from location to location. While some areas have low property taxes, some states like New Jersey, Illinois, and New York are notorious for high property taxes. Get an estimate of your property taxes, usually divided up and included in your 12 monthly mortgage payments.
Homeowners Insurance
Homeowner’s insurance costs vary by location, home value, and other risk factors. You may also want to add on earthquake or other specialty coverage that’s not covered by standard homeowner policies in some areas. The National Association of Insurance Commissioners reports an average of $1,249 per year for homeowners insurance, which translates to $104 per month. However, if you own a more expensive than average house, your costs can be higher. In many cases, this insurance is also divided up over the year and added to your mortgage payment through an escrow account.
Flood Insurance
Your homeowner’s insurance probably covers your home from water damage when the water is falling from the sky, but it’s not covered if the water comes up from below. Flood insurance is sold through a national insurance program. If you live in an area with any flood risk, it’s wise to get this insurance, which is another cost to pay every month or year.
Private Mortgage Insurance
Private Mortgage Insurance (PMI) is an insurance most lenders require when making a down payment of less than 20%. The White Coat Investor recommends buying a home with 20% down or more for several reasons, including avoiding this added monthly cost. PMI protects the bank, not you. You don’t benefit at all from paying it. If you decide to put less than 20% down, get a doctor mortgage. There is really not reason for a doctor to ever pay PMI.
Homeowners Association Fees
If you live in a condo, townhouse, or covenant-controlled community, you likely have another monthly cost to pay: homeowners association (HOA) dues. HOA fees may give you something in return, like trash service, security, snow removal, and landscaping. Most HOAs require regular monthly dues, and they may require one-time assessments for major projects.
Home Maintenance
If you’re a renter and your dishwasher, refrigerator, or furnace breaks down, someone else has to pay for it. As a homeowner, all costs land on your shoulders. The average homeowner spends $170 per month on repairs and general maintenance. If you pay for professional lawn care and snow removal, that averages $130 per month. Plus, if you want to make any upgrades, you’ll foot the bill there, as well.
Utilities
Homeowners pay their own utility bills, such as water, electricity, and natural gas. You’ll also likely want home internet, and maybe a landline or cable TV. These costs vary by location and home size. You can work with your real estate agent to get an estimate of utility costs from the prior owner in some cases to get a specific estimate.
Furniture and Home Decor
While it’s not an ongoing monthly expense, most people have some big upfront costs to furnish a new home. If you need a new bed, couch, or dining set, you could wind up spending thousands of dollars in a few weeks.
More information here:
Don’t Overspend or Sell Yourself Short
It’s easy to dream too big or estimate too low when starting to house hunt. Instead of guessing, take a few minutes to calculate what you can actually afford using your debt-to-income ratio and down payment savings (or estimated proceeds from selling your current home). When you follow the numbers, you should find yourself in a great home that you can comfortably afford.
WCI Recommendations
Just because someone will give you a mortgage does not mean you should take it. A lender may be fine with a DTI ratio of 36%, but that might keep you from ever building wealth, especially given how much more you pay in taxes. We generally recommend you keep your mortgage to less than 2X your gross income. Although white coat investors have had to stretch that guideline a little in high cost of living areas, doing so comes with consequences—fewer vacations, less nice cars, no private school, a less luxurious retirement, or a longer career. Stretching is 3-4X, not 10X. Another useful guideline is to keep all housing costs—mortgage, insurance, taxes, and utilities to less than 20% of gross income. That should be low enough to allow a doctor to still build wealth, and that should still provide a very nice house in most areas.
Have more questions about mortgages, particularly physician mortgages, and what would be the best option for you? Look at this WCI-vetted list to help you sort it out.
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