How much mortgage can I afford? One of the fundamental tenets of the American Dream is the pride and accomplishment that comes with owning your own home. Indeed, it is a dream that millions of Americans find themselves conditioned to be in pursuit of.
Home ownership gives you a sense of creative control over your dwelling and domicile. It is also commonly believed to be an investment vehicle that will carry you forward into retirement. (After all, once you paid off your mortgage in full, the house belongs to you completely. Thus, you are no longer are held responsible for making mortgage payments).
Things to Keep in Mind before Applying for a Mortgage
However, the question commonly arises as to how much mortgage can I afford? The answer to this question, unfortunately, is not as clear-cut and straight-forward as one might like it to be. It is said that one’s home is considered to be one’s biggest and heftiest financial investment. That’s mainly due to the substantial price tag associated with it.
Unfortunately, the costs associated with purchasing and maintaining a home are not always linear, predictable, and stable. There is a great deal of variability with respect to the total cost of home ownership. It is not like purchasing a piece of furniture or some toy. That one generally has a flat cost which you pay (or finance) at the store.
Before we calculate and answer the question of how much mortgage can I afford, it’s important to be well-informed. The next part will see what are all of the hidden and unexpected costs that are associated with home ownership:
There are a number of fees you must pay up front at the time of purchase. These are separate from and in addition to the actual purchase price of the home. These are called closing costs. Before you even start paying for the mortgage, you must have this money saved up. Be ready to pay on the date of purchase of your new home!
In some cases, it may be possible to negotiate having the closing costs paid by the seller, so that you don’t have to pay them. In some cases, it may be possible to negotiating having the closing costs rolled into the mortgage loan, so that you don’t have to come up with the money upfront.
Closing costs can run several hundred to several thousands of dollars, depending on the purchase price of the home, and depending on the various fees that you are required by law to pay in order to complete the transfer of the property deed and to originate the mortgage note.
When you purchase a house, you typically cannot borrow 100% of its purchase price. Prior to the housing market crash of 2008, this used to be commonplace, but it has since been eliminated as an option by most banks. The question of how much mortgage can I afford has vastly different implications in today’s post-housing bubble world, versus before.
Borrowers are typically required to pay anywhere from 3.5% to 20% of the purchase price of the home as a down payment in cash. The rest of the purchase price can be financed through a mortgage. The amount you are required to put down varies depending on your credit score and your income.
Private Mortgage Insurance
If you put less than 20% down toward your house, then you may be required, by law, to additionally pay private mortgage insurance (PMI), which is anywhere from 0.5% to 1% of the mortgage amount. This amount is included with each mortgage payment.
What happens if your home incurs significant damage or destruction that requires a hefty cash outlay in order to repair or to restore? This is where homeowners insurance comes into the picture. Chances are, if you are obtaining a mortgage for your home, the lender will require you to carry homeowners insurance, which is an annual premium you need to pay. Typically, the insurance is made into 12 monthly payments and is put on top of your overall mortgage payment.
In addition to your mortgage payment, pretty much every municipality and every state in the USA requires homeowners to pay an annual property tax, which is based on a percentage of the purchase price of the home. This property tax is typically included as part of your overall mortgage payment.
In the USA, whenever you borrow money from a bank, you must repay not only the principal balance of the loan, but you must also pay compound interest. This is how the mortgage company profits off of the loan. The mortgage interest is rolled into the loan and paid every month as part of the overall mortgage payment.
Now here is where it gets a little bit tricky. Each of the costs above are fairly static and invariable, for the most part. Unless property taxes are raised or lowered by the government in a given year, or insurance premiums change.
But then there are the costs associated with maintaining the home. If you have ever rented a house or an apartment, then most likely you have an agreement with your landlord where they will take care of any and all maintenance issues that arise. None of it is your responsibility, physically or financially.
Maintenance costs include repairs, upgrades, tune-ups, cleaning, and upkeep to any physical part of the house, be it internal or external. As a homeowner, you are 100% responsible for the physical and financial burdens associated with anything that arises, unexpectedly at any time. While there is no way to accurately predict when you will need to spend money on repairs, or how much you will need to spend, many financial experts recommend, as a rule of thumb, that you set aside anywhere from 1% to 3% of the purchase price of your home each year in a separate savings account, dedicated for home repairs, maintenance, and upgrades.
When it comes to selling a house, keep in mind that unlike a rental home, where you can just pick up and leave at the end of the lease, with a house, you must pay closing costs to sell the home, you may end up paying a real estate agent a certain percentage of your sale price in commissions, and you may end up having to keep paying the monthly mortgage payments on your home every month, indefinitely until you find a buyer and agree on a closing date.
So How Much Does It Really Cost? How Much Mortgage Can I Afford, Realistically?
Renting an apartment for $1000 per month is not the same as buying a house that has a $1000 per month mortgage on it. There are many upfront costs you must pay. There are a number of maintenance costs you will inevitably have to pay. The amount of money you pay for the mortgage does not all go toward building equity in your home. Part of it goes toward taxes and insurance. And when you go to sell the home, you will incur additional closing costs as well.
How Much Mortgage Can I Afford As Percentage Of Total Income?
Many financial experts will advise you to keep your total housing expenses at or below 30% of your total take-home pay. Total housing expenses would therefore include your mortgage, your property taxes, your homeowners insurance, as well as your home maintenance savings fund.
Why? Obviously you need to have money to live the rest of your life. You don’t want to be stuck in a situation where all of your money goes into housing. If that happens, there will be nothing left for other living expenses, other savings, and even for entertainment.
Tax Deductions and Other Pitfalls
One of the biggest selling points touted in favor of home ownership versus renting is the fact that the property tax and the mortgage interest that you pay are tax deductible. That means that you pay less money overall in taxes as a result.
However, don’t you fall for the lure of paying lower taxes. You must consider that you are in effect actually still paying more money toward home ownership costs. That’s just to be able to have a portion of them offset by lower taxes.
Furthermore, keep in mind that even if you pay off your mortgage after 15 or 30 years, your property tax liability never ceases. You will forever owe property tax annually on your home, even if your mortgage is paid off on it.
Property Value Appreciation
However, there is one thing we learned by the housing bubble and subsequent bust in 2008. That’s that the fact homes can appreciate in value over time is a bonus, but is also never guaranteed.
The American Dream
Buying a home is much more expensive proposition. However, if you do the math right, you can end up with a win-win situation. Next time you ask yourself the question how much mortgage can I afford, you will want to avail yourself of a good home affordability calculator.
All images taken from depositphotos.com.