*This post may contain affiliate links. Read my full disclaimer here.
For years I've toyed around with the idea of homeownership.
It seems like every time someone finds out that I’m still renting I get the same response. "Why?! Don’t you know a mortgage costs the same amount or less than your rent?"
At first, I would slap myself on the wrist for being so “dumb” and excitedly browsed through listings on Zillow. I’d check the mortgage payment estimators for the homes that I’d fall in love with, but the amounts would immediately cause my eyebrow to go up.
I decided to do my own research to see what this homeowner talk is all about. If you're thinking about buying your first home, here are the answers to the questions I know you’ve been asking!
WHAT'S INCLUDED IN A MORTGAGE PAYMENT?
Principal. This is the original amount of your loan (what you borrowed). If you get a 150,000 mortgage loan then that is the principal.
Interest. The devil! JK (or am I?). This is the rate that you pay the lender for your loan.
Taxes. Ah, yes. Everything must come taxed, right? Real estate taxes are added to your mortgage payment and it is often based on your property’s value.
Insurance. You don’t want your dream home to burn to ashes because of a Thanksgiving turkey so insurance is there to protect against damages. If your home is purchased with less than 20% down, then you are required to pay private mortgage insurance (PMI) fee in addition to your insurance.
What is PMI?
PMI stands for private mortgage insurance. It protects the lender (not you) in case you stop making payments on your mortgage and go into foreclosure. It is often added to your mortgage payment, thus increasing the amount.
PROS OF HOMEOWNERSHIP
- Tax breaks. Homeowners receive some of the biggest tax breaks on interest paid, property taxes, etc.
- Privacy. When you’re renting, your neighbors are often above you, beside you, and/or below you. Buying a home gives you more privacy and free reign to do as you please.
- Fixed-rate mortgage. Mortgages often have a fixed rate, which means the payments don’t fluctuate.
- Equity. In simpler terms, home equity is the portion of the home that you actually own. As you pay down your mortgage loan, equity is built.
- Bragging rights. There’s nothing more satisfying than being able to tell everyone that you just purchased your first home!
CONS OF HOMEOWNERSHIP
- Maintenance and repairs. When you buy a home, all maintenance and repairs are on your dime.
- You have to stay put. When you’re locked in a mortgage, you lose the flexibility of picking up and changing locations.
- Down payments and closing costs. Renting often requires a small deposit, but when purchasing a home, down payments and closing costs can put a huge dent in your account.
HOW MUCH HOUSE CAN I AFFORD?
It’s easy to get caught up in the “new house feels” when you’re super excited about buying your first home. In fact, you may be so excited that you completely forget about your other monthly expenses when you’re determining how much house you can afford.
Trust me, I know.
No more than 36% of your gross income should be used on debt, such as student loans and car loans. This also includes your mortgage payment.
For example, let’s say that your gross income is $5,000 each month. This means that your mortgage and other debt payments should not cost you more than $1,800. Otherwise, you’ll be trapped in the rat race aka paycheck to paycheck lifestyle.
Yes, your home is lovely but you’ll never truly get to enjoy it because you’ll be too busy working to afford it!
In addition to the 36%, no more than 28% of your gross monthly income should be spent on household expenses.
When you’re budgeting for a new home, you have to leave some wiggle room for retirement savings and future expenses.
Think about it for a second here. When you’re locked in a 30-year mortgage are you really going to go 30 years without taking on a new expense, such as a new car? Probably not.
Personally, I’d opt to use my net income (take-home pay after taxes) to calculate these percentages because..umm..we all know that gross income is not what’s deposited into our bank accounts!
Doing this will give you a more accurate idea of how much you can really afford.
Maximum monthly house payment
To calculate the maximum amount you can afford as a house payment, Dave Ramsey himself advises multiplying your income by 25%. So, if your monthly income after taxes/deductions is $4,000 then your house payment should be no more than $1,000 (4000 x .25).
DO I QUALIFY FOR A HOME?
Although lenders will have varying requirements, certain qualifications are pretty standard.
Credit score. Your credit score is one of the leading factors in determining your eligibility for a mortgage loan. It is recommended that you have a credit score of 680 and above.
Anything less than 620 may result in higher interest rates, larger down payments, or even rejection.
Lenders will often look through your credit history for things, such as any late payments, to determine the likeliness of you paying back your loan.
*I recommend using Credit Sesame to check out your credit score and credit report beforehand. It’s completely free and helps to strengthen your score by showing you what is negatively affecting it and how to fix it. You can also get your credit report from Annualcreditreport.com.
Things to take into consideration
- Income. It should come as no surprise that you must prove you have a consistent stream of income. No money means you cannot pay back a mortgage loan.
- Down payment. Lenders often require a down payment to motivate you to make your mortgage payments. If you lose the home, you lose the down payment you made as well.
It is recommended to have at least 20% of the purchase price to put down, although more people are now putting down less than that amount. By paying at least 10% of the purchase price upfront, you’ll be saving yourself interest and knocking down the term of your loan.
- Debt-to-income. Your debt-to-income (DTI) ratio should be no more than 36% of your gross monthly income. According to Bankrate, many lenders won’t consider a borrower with a DTI above 43%. The higher your DTI, the harder it is to get approved for a loan.
Think about it. If someone that has more debt than income wants to borrow from you, would you lend them the money? Probably not because you don’t believe they will be able to repay you! It’s the same with lenders!
Rip through as much debt as you can before applying for a mortgage loan to increase your chances of getting accepted with a low interest rate.
FRONT-END AND BACK-END RATIOS
Lenders will often use front-end and back-end ratios to determine how much you can afford.
The front-end ratio will be your monthly housing expenses (mortgage payment, insurance, etc.) divided by your gross income. Your mortgage payment shouldn’t be over 28% of your income before taxes.
The back-end ratio will be your monthly debt payments (loans, credit cards, etc.) divided by your gross income. Your back-end ratio should be no more than 36%.
If you read the qualifications and have determined that you don’t qualify, don’t be so quick to cross homeownership off your list. There are multiple programs available to help you purchase your first home.
- FHA loans. These loans are backed by the Federal Housing Administration. It is a popular choice for first-time homebuyers and those that do not qualify for conventional loans. With a credit score of 580 and above, you can put down just 3.5% of the purchase price.
- HUD homebuyer programs. Homebuyer assistance programs are offered from state to state but have varying qualifications. These programs often offer grants to help with closing costs and down payments for those who qualify.
A simple Google search for homebuyer assistance in your state should direct you to these programs, or you can find them through the HUD website.
- VA loans. VA loans are offered to retired and active vets that require no money down or mortgage insurance.
- USDA loans. This program is offered through the U.S. Department of Agriculture to homebuyers in rural areas with low to moderate incomes. It requires no money down and comes with cheaper mortgage insurance.
IS BUYING CHEAPER THAN RENTING?
This answer will vary from person to person. Factors such as location, age, and income certainly come into play! For me, renting is the cheaper option.
Many may wag their finger in disapproval of you “wasting money” by renting, but buying your first home is a huge financial decision and one that should be made only when you are ready.
Buying your first home comes with many perks, but also many expenses. It’s extremely important to go into the process properly educated and financially prepared. No one wants their dream home to turn into a house of horrors so be sure to do it right!