You are ready to make the jump from renting to buying a home. That is good news. Buying a home today is more affordable than it has been in decades. The National Association of Realtors reported that in November 2016, the median sales price of existing homes across the country stood at $234,900. That is a 5.4% percent gain from November 2015. That is good news for sellers, but bad news for buyers.
At the same time, borrowing money to finance a home is getting more costly, too. For December 2016, Freddie Mac reported that the average interest rate on a 30-year fixed-rate mortgage rose to 4.30 percent, which is slightly higher than the prior year rate and still relatively low by historical standards.
Homes are still very affordable, but that does not mean that you can afford to buy that dream home you've located in your ideal neighborhood.
Before you buy a home, you want to make sure that you can afford the monthly mortgage payment. If you cannot, you'll struggle to make your payments on time. Moreover, you could even end up losing your home to foreclosure.
Can you afford it?
In general, mortgage lenders recommend that you purchase a home that is no more than two-and-a-half times your gross annual income, your income before any tax deductions.
In general, then, if you make $50,000 a year, you'd be able to afford a home that costs from $100,000 to $150,000.
Of course, that is a fairly simplistic formula that doesn't take into account other factors. You might make $50,000 but have few other debts. Maybe you do not have any credit card debt and are not burdened with student loan debt. You'll be in a much better position to afford a more expensive home than someone making the same amount of money as you, but with overwhelming student loan and auto payments and high credit card bills.
What your lenders will give you
Mortgage lenders will look at your entire financial picture to determine how much money to lend you.
This includes both your monthly income and your monthly debts. In fact, lenders rely on two ratios -- the front-end and back-end ratios - to determine how large of a mortgage payment you can afford.
The front-end ratio determines how much of your monthly income your mortgage payment -- including principal, taxes and insurance -- takes up. Lenders want your mortgage payment to take up no more than 28 percent of your monthly income. The back-end ratio takes into account all of your debts, everything from your mortgage payment to your credit card debt to your student loans. Lenders want your monthly debts to total no more than 36 percent of your gross monthly income.
The down payment
Of course, you can increase the affordability of your mortgage loan by coming up with a larger down payment. The more money you can put to a down payment, the smaller your mortgage loan will be, and the smaller your monthly payment will be.
Most conventional lenders today require that you put down at least 5 percent of your home's purchase price. Down payment requirements will vary though, based on your credit history and other factors.
According to EllieMae, statistics for 2016 indicate that, with more and more first-time homebuyers entering the market, down payments percentages have decreased, with fewer home buyers putting down 10 percent or less. For a house with a $200,000 purchase price, that would come out to a down payment of $20,000. If you take out a mortgage loan insured by the Federal Housing Administration, though, you'll need a down payment of just 3-and-a-half percent depending on your three-digit credit score. For a house with a $200,000 purchase price, that comes out to a down payment of $7,000.
Of course, even if you can afford a specific house, and you have the money for a down payment, you might not qualify for a mortgage loan. That is because lenders today rely heavily on your three-digit credit score when determining who gets mortgage money and at what interest rate.
If you have a credit history filled with missed credit card and car payments, your credit score will drop. If you've filed for bankruptcy or suffered through a housing foreclosure, your three-digit scores will plummet. Your score will also suffer if you have mountains of credit card debt.
However, if you've made wise financial decisions, and you've paid your bills on time, your credit score should be solid. In general, lenders reserve their best interest rates for borrowers who have FICO credit scores of 740 or higher.
That is important when it comes to affordability. Your monthly mortgage payment will be lower if you have a lower interest rate. The best way to get a low rate is to come to your lender with a strong credit score.