If you are a first-time homebuyer, the biggest question on your mind is probably how much you can afford. You have questions like, what is a bank willing to give me on a home loan? Is it going to be a million dollars? Is it going to be $20,000, and I’m stuck living in my car?
I’m going to show you the quickest and the easiest way step by step to figure out approximately how much you are going to get approved for and how much you qualify for and how much money you need for the down payment and all other related things you need to know.
Knowing how much you actually can afford is a question of how much you can get approved for and how much you can afford comfortably. Many lenders do not bring up the second question with first-time buyers, and I want to do that with you now because you might get qualified to spend $3,000 or $4,000 monthly, depending on your income and debt on your home. However, you might be used to only paying $2,000 or $2,500 in rent, and that big price hike might be too much for you to swallow, so the first thing you should do is write down the absolute maximum.
The Absolute Maximum
How much am I comfortable spending on my mortgage? Now, it’s not just your mortgage you’ll see; there are other costs involved in owning a home. Your principal and interest are your mortgage; you also have property tax and insurance. If you’re in a condo or a townhome complex, you also have homeowners association dues, and if you’re coming in with less than 20%, you’re also going to have mortgage insurance or PMI. There are many costs associated with owning a home that you might not be used to as a renter but know your bottom line. How much am I willing and comfortable to spend on a house because that payment is not changing for thirty years hypothetically speaking, if you never refinance or sell. So that payment better is something you’re comfortable with.
You don’t want a situation where you cannot afford the mortgage every month. Is it not suitable to be renting or even in a more comfortable situation in a smaller house than having a payment you can’t afford?
Down Payment and Closing Costs
The second thing you’ll want to do even before you talk about your debt and your income is to figure out how much money you have for your down payment and closing costs. So if you’re a first-time homebuyer, you probably don’t know that there are closing costs in every home purchase. These go over things like your title company, escrow company, appraisal, inspection, credit report, and mortgage insurance (if you have any). You also want to check for property taxes upfront. There are a lot of different items, so you have to have a certain amount set aside in cash for your down payment and closing costs.
There is a way to get your closing costs paid by lender credits. It always means you will get a higher interest rate, but it is an option. I have a video on that topic, so if you want to know how to get your lender to pay your closing costs and the differential on your interest rate, make sure to check here.
However, if you’re not interested in getting a higher rate for lender credits on closing costs and want to pay everything in cash, you need to look at your lump sum. This might be what you’ve been able to either save or you’re getting a gift from a family member to help you out with your purchase.
So now you have two bottom-line numbers. The first is what you’re comfortable affording, and the second is how much cash you have on hand. How much cash on hand you have is going to be crucial to figuring out if you are coming into an FHA loan, where you will do 3½% down or maybe even a conventional with 3% down as a first time home buyer; or do you have enough saved up for 20% down?
To give you a good rule of thumb, your closing costs could be anywhere between $10,000 – $15,000 on a purchase. It depends on where you are in the country and the size of the home. However, on average, $10,000 and $15,000 is what you’ll see in closing costs. So let’s say you have $100,000 saved up either by savings or gifts and let’s say your closing costs are $10,000, which means that you have $90,000 left for the down payment. If you can qualify and if there are homes in the area for $450,000, because that would be 20%, I would say go for the conventional loan and let’s work on the next step, which is qualifying your income.
However, if you don’t have that and only have $30,000 between two people. Perhaps, you’re married, or you’re living with somebody, and you plan to buy the house together, and you’ve managed to save you know $25,000 and your parents or a relative is giving you another $5,000. So, in total, you have $30,000 to your name. In that case, I’d say you’re probably looking at an FHA loan with only 3½% down. 3½% down of the same property ($450,000) will be around $15,000, a little bit more plus that down payment and closing costs of $10,000. So you’re kind of right around that range. Those down payments can qualify you for a house of around $450,000.
Obviously, in certain areas like San Francisco or Los Angeles, that will not get you much. However, in certain parts of the country, that’ll buy you a very large house that you can live in with your family for the rest of your life. So it depends on your market, and you probably already know what a house costs because if you’re reading this, I guess you’ve probably been on Realtor, Trulia or Zillow and looking at what houses cost and you kind of know how much you need to spend.
Cash on Hand and Debt to Income Ratio
Now that you have that bottom line number on how much cash you have, it’s time to find out what your maximum output on your income will allow you to qualify for. So it’s a combination of the two: cash on hand and your debt to income ratio. How much debt you have versus how much you earn.
I’m going to make the debt to income as simple as possible. It’s not something you can do in two seconds, but you could do it pretty quickly, and once you’ve done it, it’s no longer a problem for you. It’s not a complicated formula; many people are doing this all over. Being a loan broker is not brain surgery, but it’s a bit secretive if you’ve never done it before, and I’m here to explain.
The first thing you want to do is figure out if it’s just you or you and a partner on the loan. You take both incomes that you earn together monthly and take the gross. You must take the gross amount, not the net, so if you’re used to seeing your paycheck, and it says $2,000 or $3,000, and you’re a w-2 employee, that’s not what you make. You make much more, but they’re taking a lot out for taxes, so make sure you know your gross monthly amount. If you’re salaried, it’s probably easiest. Let’s say you make $40,000 a year; you divide by 12; that’s your gross monthly salary. Let’s say you’re both earning $40,000 a year, and so you have a combined gross yearly income of $80,000 and if you divide that by 12, that gives you $6,666.67. That’s a little over $6,500 to work with.
Now, divide that gross income in half; multiply it by 0.5 or using a calculator, you can divide it by 2. Back to our example, that leaves us with $3,333.34. Why are we dividing it in half? The maximum debt to income ratio they’re going to want to loan on is 50%. They don’t want to give you a loan for your house where your total housing payment, PITI, as we call it (Property, Principal Interest, Tax, and Insurance), is more than half of your gross pay. Anything over that, the loan will get denied, so that’s your maximum. Ideally, you want to get not quite to 50. You want to be in the low-40s or mid-40s.
After you divide it and you get your half, subtract your debts. What are debts? Debt is not your cell phone bill or your gas. It’s what shows up on a credit report. The big three will always be student loans, credit card payments and car payments.
Let’s take them one at a time.
This is how much you pay per month, not how much you owe on the car or how much you think you can pay every month because you’re paying extra. It is what you owe per month, whether it’s leased or on a purchase plan. What is the monthly required, because that’s what will show up on your credit report. So if you have two cars, there are two people, and you’re each paying $350 a month, that’s $700. We’ll take off $700 from the previous $3,333.34 for the car payments, which leaves us with $2,633.34. Right away, we’re just going to subtract the debt from that 50%.
Credit Card Debts
We’re looking at the lowest minimum monthly payment on credit card debt, so even if you owe three thousand dollars on a credit card, that minimum monthly payment might only be a hundred bucks. Add up all the credit cards with minimum monthlies. If you’re the kind of person who doesn’t use your credit cards but has several open, know that even though you never use them, they will charge you that minimum monthly payment. Hence, you have to factor in anywhere from $25 to $50 per credit card that you have open as debt.
If you don’t have any student loans, you’re good to go. The other things that might be on are medical debt or personal loans or other things that might show up again on your credit report. However, student loans tend to be the most common.
Suppose you’re on a forgiveness plan where they don’t charge you on your student loans. Perhaps they forgive the loans for a while. It’s not a true forgiving because they’re making you pay it later, but they’re not making you pay monthly. So, if you don’t have a monthly amount that you pay every month on your student loans, you have to take the total amount you owe and multiply it by 1%. So if you owe $10,000 in student loans, you’re going to have to get 1% or $100 of debt per month.
Here’s a cool trick here, if you tell your loan officer that student loans are a big part of your debt, perhaps, you have $200,000 in student loans, and you’re not paying any of them, which is going to hurt your debt to income, you can kind of negotiate that a little bit. It’s not really negotiation but what you can do is instead of going with a Fannie Mae product, which is a type of loan, you can go with a Freddie Mac product. A Freddie Mac product is done on a different underwriting system, called LPA. With it, you will get as low as 0.5%, so instead of getting 1% of that student loan hitting your debt to income. You can divide that again so instead of $10,000 being a$100 debt every month; you can bring it down to $50 a month, which is a huge difference, especially with people who have bigger loans. I’m not going to go into what Fannie Mae and Freddie Mac are right now; tell your loan officer, lender, mortgage broker or call me and I’ll tell them you want to go with an LPA or a Freddie Mac loan because your student debt needs to be calculated at ½%.
Pro-tip, that’s an excellent tip that a lot of people neglect. Don’t forget. Last I checked on our tally; we were at $2,633.34. I’m going to make this nice and simple. I’m going to say between credit cards and student loans, you have $233.34, which brings us down to $2,400 even.
So $2400 is what you’re allowed to spend per month for your principal, interest, tax and insurance if it’s a single-family home. If it’s a condo, add in your HOA, and you’re coming in with less than 20%, you will add in your mortgage insurance or your PMI. This means that you will have between four and six things that $2400 needs to cover every month. Now, I will break out my little mortgage calculator on my phone to break down the numbers for you. At $450,000, 20% is $90,000. I’ll put an interest rate of 4%, which is about where they’re now for the kind of loans I get on the wholesale side. For the property tax in California, it’s different per county; I usually think of it as 1.25%. If you’re in another state, it might be higher or lower. In Texas, it’s a little higher. It’s about 1.25 in California. Your homeowners’ insurance policy again if you’re a single-family home: somewhere around $100 a month, so if you add all that up, on a 4%, that will give you $2,287/mo in your total payments.
That’s your PITI (principal, interest taxes, and insurance). It is under our $2400, so you’ll be approved for that. You might get approved for slightly more but not a lot more. So if you just up it to 475, you’re still good; it’s $2408. You’re just eight dollars over, so there might be something you can play with. Perhaps, you could pay off a credit card or close a credit card. However, don’t do anything without talking to your loan broker first. You could start looking at properties from $400,000 to $450,000, and then if you need to, you can go into the $475,000 on a what you’ll call it on a counteroffer or something like that.
If you’re doing an FHA loan, things will be drastically different. To start with, you’re borrowing a lot more money. So instead of borrowing 80% of the loan, you’re borrowing 96½% of the purchase price. The benefit of an FHA loan is that the rates are almost always lower unless you have bad credit, in which case they’re going to be similar to a conventional loan. However, assuming you know you have decent credit, the FHA loan will be almost a percent on average lower than a conventional loan; for someone with excellent credit, you might not be paying 4%, you’ll be paying down to like 3%. To keep the numbers simple, I’m going to use my little mortgage calculator here, and for the interest rate, I’m going to put it at 2.99, which is a very common rate that we see. The property tax is the same at 1.25, and the homeowner’s insurance is the same at $1200. Now, your mortgage insurance on an FHA loan will be 0.85 of the loan.
To put that in perspective, $308 of your monthly payment goes to mortgage insurance because you haven’t come in with twenty percent down. Your total payment is $2,704, which is $300 over what you can afford with your income. So if you were on an FHA program and were earning the same as the conventional people, you’d have to go down about $400. With this, you’re 15 over, and you’d probably be looking at something around $375,000 on an FHA program with the same income. This is because you have less of a down payment.
Maximum Debt to Income
How do you figure all this out in terms of the numbers? You got the number you have in cash and the number you’re comfortable paying, and then you have the third number, which is how much your maximum debt to income is. This is where you take your payment, divide it in half, and subtract your debt. After doing these three, you know which range you’re in. Then you can go to google and type in “mortgage calculator”. Google has one in the search field, where you can type in your loan amount, not the purchase price but how much your loan is for. So if you’re coming in with 3½%, take it off the purchase price; that’s your loan amount. It’s the same thing with 20%; take 20% off the purchase price, that’s your loan amount, and you’ll get a rate.
You have to figure out your mortgage insurance and your property taxes. Your mortgage insurance figure is about a hundred bucks a month, just as a rule of thumb. Your property tax will be whatever it is for the state, so if you’re in California, it’s 1.25. If you want to figure out your property tax, you can use your iPhone calculator. Let’s say your home price (what you bought it for), not the loan amount, but your purchase price is $400,000. Now, we will multiply that by .0125, which is 1¼% and that gives us $5,000 a year. We’re going to divide that by 12, and we will $416.67, which we can round up to $417. Now, $417 will be your property tax; coupled with another 100 bucks for your insurance; you’re out $517.
Add that to your mortgage and you’re good to go. This is how you do the numbers quickly. You can get the mortgage calculator, which is a little too complicated to do without a big formula, so find a mortgage calculator and find out your principal and interest. That way, add your property tax and your insurance. If there’s an HOA, add the HOA. If there’s mortgage insurance or PMI, if you’re on an FHA loan or coming in lower, the calculator can do that too. Usually, that gives you your monthly payment. Does it fit within your max? Is it comfortable enough for you? If the answers to these are ‘Yes’, you’re good to go; that’s how you figure out what you qualify for.
If you have any questions, you can leave them down in the comments below.