Step 2: What is My Price Range?
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Sellers (and their agents) will not allow you to visit their homes that are for sale unless you have a pre-approval. There is no “just looking” in homebuying. The pre-approval proves you really do have MONEY.
To estimate your price range you need to know your yearly gross (before tax) income. If you’re unsure of how much you make in a year it should be on your tax documents. Also, you can include overtime if it’s consistent and documented. Be prepared: As in my case, a lender may not be willing to consider sporadic overtime as part of your income because it’s too inconsistent to include in your monthly payment. All the examples will use an annual income of $40,000.
Here’s the main formula:
$Mortgage + $Down Payment = $Home Price
EX: $120,000 + $5,000 = $125,000
You also need this one:
$Down Payment + $Reserves + $Closing Costs = $Total Savings Needed
Grab some paper and a calculator and we’ll work these out right now!
Mortgage is Based on Your Income
Using a standard method accepted in the real estate industry, take your gross (before tax) income and multiply it by 3. (If you have monthly payments on existing debts that are over 28% of your monthly income you may not qualify for a mortgage quite as high as the amount you are about to estimate but keep going.)
$Income x 3 = $Mortgage
EX: $40,000 x 3 = $120,000
You can clearly see that in order to increase your mortgage amount you will need to increase your income. Picking up more hours or a second job is not going to work unless you want to maintain those extra hours or second job while you’re paying your mortgage. If you increase your income now and then decrease it after you buy the home your mortgage payment will be too high.
Almost everyone does not plan to, but ends up using the entire mortgage amount they qualify for (the whole $120,000 in the example). It’s a good idea because lenders base your mortgage amount on your current income—as if it will never increase—but in reality your income does increase over time. Your first instinct will be to cheap out “just to be safe” but once you see how much cooler the houses are with those few extra thousand dollars you will spend the whole amount just like everybody else. It may feel like a splurge but it’s a good money move to take advantage of your full borrowing potential now. Your payments will feel high now but in the future, when your income increases and your mortgage payment stays the same you’ll be glad you opted for a more expensive home.
Down Payment is Your Savings
All of the money used to buy a home must be saved out of your own income. Lenders will look at all of your available financial information (tax returns, bank statements, etc) for the past year and possibly up to three previous years so they’re going to know where all your money came from. Any gift checks that you receive to help buy a home will need to be photocopied. Each lender has a statement prepared for you and the gifter to sign saying that the money never needs to be repaid.
If you’re considering borrowing from an IRA or 401K make sure you do the legwork and are as informed as humanly possibly about the consequences. For example, if you borrow from your work 401K and get fired or leave your job you will have to pay it all back right then. That means even if you wanted to quit you’d have to save the same amount of money that you just borrowed which will be hard with a mortgage payment AND payments on the 401K loan. Personally, I think borrowing from a retirement fund is a bad idea. It’s taking a shortcut because you can’t really afford to buy a home right now and would rather choose debt and instability over waiting and saving.
How much will your down payment be? At the very least, it has to meet the FHA’s minimum down payment of 3.5% of the home’s price. Most first time buyers use the FHA because it’s cheaper in many ways. (Sidenote: You do not contact the FHA directly but work through a lender just like conventional mortgages. Your lender will show you the FHA option and the conventional option, which has a minimum of 5% down and harsher interest rates for first timers.) You can put more than 3.5% down and still use the FHA but first find how much you need to put down if you only did the minimum 3.5%. This is a two step process.
Step 1: Use the mortgage number you just calculated to find the home price with 3.5%.
$Mortgage / (1 – Down Payment%) = $Home Price
EX: $120,000 / (1-0.035) OR $120,000 / 0.965 = $124,352
Step 2: Subtract the mortgage from the home price to find the down payment amount.
$Home Price – $Mortgage = $Down Payment
EX: $124,352 – $120,000 = $4,352
Reserves are Your Savings
Your down payment number probably looks very do-able and you can always put down more than that, but would you be dead broke after it left your bank account? Lenders want to see 1 to 2 months of housing payments or “reserves” left in your bank account after you buy the home… just to make sure you don’t fall on your face right out the gate. Be very aware that, while saving a down payment is fantastic, you need to save a little more to secure a mortgage. Let’s calculate reserves because, unlike closing costs, they are not optional.
$Income X 0.05 = $Reserves
Ex: $40,000 X 0.05 = $2,000
Closing Costs are Your Savings
You may or may not want to save for closing costs. They are about 5% of the home’s price and are fees paid to the lender and taxes paid to the government when you buy a home. Because lenders get to set their own prices for the fees part of closing costs the amount you will pay will vary depending on the lender. Some will charge more, some less. Shop around and get multiple mortgage pre-approvals. You can ask the seller to pay closing costs for you when you make an offer, but your offer will be less attractive than another buyer who is willing to pay closing costs.
For example, you are looking to buy a $124,000 home and want the seller to pay for closing costs. Closing costs are about 5% of the purchase price, or $6,200. If you were to offer the full asking price of $124,000 you are really only offering the seller $117,800. It’s like saying, “I’ll pay you $124,000 but you have to give $6,200 of it back immediately.” Your offer isn’t really the asking price, but a 5% discounted price. If you plan to ask the seller to pay closing costs, be careful not to shop far above your price range because you are automatically asking for a 5% discount.
To budget for closing costs, you’ll need about another 5% of the home’s price. I know that’s more than the down payment! This number will look HUGE but it’s worth it if you get the home you want. Take your home price number and multiply it by 5%.
$Home Price X 0.05 = $Closing Costs
Ex: $124,352 X 0.05 = $6,218
Total Savings Needed (The Minimum)
Find how much you need to save in order to buy a home by adding up the down payment, reserves, and closing costs. You don’t have to include closing costs but I’d encourage you to. You’ll be really disappointed when you can’t get the home you want because the seller won’t or cannot afford to pay your closing costs. Think about it… they’re trying to make a profit when they sell their home and some stupid first time buyer wants them to pay closing costs so they’ll barely make any money! How can they afford the down payment on their next home with you bleeding them dry! Damn!
$Down Payment + $Reserves + $Closing Costs = $Total Savings Needed
$4,352 + $2,000 + $6,218 = $12,570
That is your goal!
What if you save more? You have 2 options because $Mortgage + $Down Payment = $Home Price
Original EX: $120,000 + $4,352 = $124,352 What if they have $10,000 instead of $4,352?
Option 1: Have a down payment that is more than 3.5% and reduce the mortgage amount. The monthly mortgage payments will be cheaper. Landlords do this.
EX: $110,000 + $10,000 = $120,000
Option 2: Have a 3.5% down payment, don’t reduce the mortgage amount, and buy a more expensive home. Keep in mind that closing costs will go up a little when the home price goes up.
EX: $120,000 + $10,000 = $130,000 Oh Yeah!
Why weren’t interest rates part of this? Interest rates determine how much interest you will pay on your mortgage, mortgage, mortgage, not home price. Your mortgage payment may be slightly higher or slightly lower depending on what’s going on with interest rates when you actually get a mortgage. Interest rates will go up and down during your search for a home but your price range will stay the same because the mortgage amount you were pre-approved for will not change when interest rates change slightly. If you take a long time to buy then your mortgage pre-approval might change if interest rates have significantly increased or decreased. Different lenders offer different mortgage rates. Some will be high, some low. Shop around and get multiple mortgage pre-approvals.
How Much is the Monthly Payment?
You won’t be able to come up with a monthly payment number because it varies from individual home to home. A housing payment has a mortgage AND up to 4 non-mortgage parts. Only #4 is not required by law. For more information read Why Owning Costs More than Renting (per Month). You can Google for the monthly payment amount for the mortgage you calculated above and then DOUBLE IT. That is more like what your monthly payment will be.
1. Property Taxes (This amount is different for every home.)
2. Homeowners Insurance (Yes, it’s required.)
3. Mortgage Insurance (Required unless you put 20% down. 1st timers never put 20% down.)
4. Association Fee (The neighborhood may or may not have one.)
Now that you have an estimate it’s time to ask yourself if you’re really ready to put this thing in motion. Step 3 is about finding a real estate agent, so ask yourself: Do you have enough saved? If not, spend some time setting goals for each pay check and figure out when you’ll be able to afford to move forward. Check your credit through a non-lender inquiry and look for errors. Pay your credit cards down as low as you possibly can and stop using them! Also check out Realtor.com to see if you even like the kinds of listings in that price range. First time home buyers are on the bottom rung of the salary ladder so don’t expect to be in the middle range of home prices.
Pre-approvals should really be called “mortgage pre-approvals.” You will not be pre-approved for a home’s price but for the mortgage amount that a lender is willing to lend you. It’s up to you to save the appropriate amounts for the down payment, reserves, and closing costs that go with it.
For those of you who feel ready now, here’s how to get a pre-approval. (It’s free)
Unless you have no credit history or recently declared bankruptcy, the lender will probably be able to work something out. After all, lending is a business. After you’ve concluded the phone call the lender will (hopefully) email you a pre-approval. When you get it, email the lender back and ask if they ran your credit report and if you can have a copy. Though they might not hand over the whole report, if you ask nicely and specifically they will probably tell you what your scores were from all three credit bureaus.
Don’t worry about the credit check trashing your score. Inquiries through a lender like this one make up only 10% of your total score and this one won’t even show up for a month or two. If you decide to get a pre-approval from several different lenders, try to do it within a two week time frame so it shows up as 1 inquiry in your credit report. Lenders will be able to see that you are shopping around but won’t count it against you. Good luck! You can do it!