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How much house you can afford depends on how much cash you can put down and how much a creditor will lend you. There are two rules of thumb:
- You can afford a home that's up to 2 1/2 times your annual gross income.
- Your monthly payments (principal and interest) should be 1/4 of your gross pay, or 1/3 of your take-home pay.
The down payment and closing costs - how much cash will you need? Generally speaking, the more money you put down, the lower your mortgage. You can put as little as 3% down, depending on the loan, but you'll have a higher interest rate. Furthermore, anything less than 20% down will require you to pay Private Mortgage Insurance (PMI) which protects the lender if you can't make the payments. Also, expect to pay 3% to 6% of the loan amount in closing costs. These are fees required to close the loan including points, insurance, inspections and title fees. To save on closing costs you may ask the seller to pay some of them, in which case the lender simply adds that amount to the price of the house and you finance them with the mortgage. A lender may also ask you to have two months' mortgage payments in savings when applying for a loan. The mortgage - how much can you borrow? A lender will look at your income and your existing debt when evaluating your loan application. They use two ratios as guidelines:
- Housing expense ratio. Your monthly PITI payment (Principal, Interest, Taxes and Insurance) should not exceed 28% of your monthly gross income.
- Debt-to-income ratio. Your long-term debt (any debt that will take over 10 months to pay off - mortgages, car loans, student loans, alimony, child support, credit cards) shouldn't exceed 36% of your monthly gross income.
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