The other day I was in a convenience store and happened to strike up a conversation with the store clerk about building homes. She was a young lady, but her question was a common one. HOW MUCH CAN I AFFORD TO BUY?
With all the changes in the mortgage industry, getting pre-qualified might seem more like a mystery than it needs to be. He is a simple worksheet to help you calculate how much house you can afford.
1. What is your yearly gross income? $__________ Example $ 80,000
2. Multiply your income by .4 (40%) x .40 x .40
3. Total $_________ $ 32,000
3. Divide total by 12 $_________ $ 2,666.67
4.Deduct all your monthly payments* $_________ $ - 454.00 (300 car, 154 credit cards)
5. Total $_________ $ 2,212.67
* Credit cards, car payments, school loans, lines of credit, etc.
6. The amount you have in line five (ex. $2,212.67) is an estimate of the total monthly payment you can have for your mortgage including principal and interest and the monthly taxes and insurance escrows. Prior to the market crash, some mortgage companies were approving loans at debt to income ratios of 50-55%. All those folks are the people who have lost their homes. The problem with ratios this high is the first time the car breaks your bankrupt. A 38-40% debt to income ratio is much safer and is the historical range used for more than 30 years, before all the insanity. Of course, if you can have a lower debt to income ratio all the power to you.
The next step is to break down the total monthly payment available for a mortgage payment. This gets a little tricky, but hopefully this makes sense.
7. Deduct the monthly home owners insurance amount $_________ $ -100.00
(Example is based on estimate of $1,200 yearly home owners insurance. You can call your insurance agent to get an idea of what your homeowners insurance will cost you)
8. Deduct the monthly real estate tax amount $_________ $ -250.00
(Example is based on estimate of $3,000 yearly real estate property taxes. Most county web sites have the ability to look up property taxes on-line. Look up similar properties you are interested in to get an idea of what the property taxes will be.)
9. Subtract Line 7 and line 8 from line 5 $_________ $ 1,862.67
The final step is to find out what the amount of line 9 will support in terms of actual purchase price. This will vary based on interest rate, loan term and number of payments per year. For this exercise, I am using the standard 30 year amortization period and twelve payments per year. For the interest rate, I’ve includes a few sample interest rates here, to give you an idea, but you can also use excel to do more what if exercises. Excel has a built in loan amortization tool.
To complete this next part, take the amount of line 9 and divide it by the amounts per thousand below.
10. 4.5% = $5.067 per thousand $_________ $ 367.608 = 367,608 Purchase Price
11. 5.0% = $5.368 per thousand $_________ $ 346.995 = 346,995 Purchase Price
12. 5.5% = $5.678 per thousand $_________ $ 328.050 = 328,050 Purchase Price
13. 6.0% = $5.995 per thousand $_________ $ 310.703 = 310,703 Purchase Price
It is staggering what two percentages points in the interest rate makes in terms of (gained or lost) purchasing power. In our example, we see more than $55,00 difference in purchasing power. It makes sense to buy now doesn’t it? Rates are at the lowest point in more than 30 years. Also, seems kind of stupid to loose that property you really want over $5,000 in principal doesn’t it?
OK, I will get off my soap box and get back to the final step. The final step is adding your down payment amount (cash) you plan on putting down. Different loan programs require different minimum down payments. For example, FHA requires a minimum of 3.5% down payment. Other programs require ten percent down payment and others even twenty percent.
If you know the the minimum down payment requirements you can divide the numbers about by the inverse percentage (example: 3.5% down = divide by .96.5%).
14. Add Down Planned Down Payment $_________ $ 38,555 (346,995/.1 = for a 10% down payment)
15. Used Line 11 example $_________ $ 346,995
16. Total $_________ $ 385,550
If you are using FHA, the closing costs become part of the amount you can qualify for. What this means is that you need to deduct the anticipated loan closing coasts from your targeted purchase price. If you are using other loan programs, you may need extra cash for closing costs. It is best to check with a mortgage loan officer for specifics.