Budgeting for a home, especially for first-time homebuyers, is often daunting. Common sense dictates buyers should buy the house they can afford. However, that amount is going to differ for everyone. The median sales price for a new home in January 2023 was $427,500. So where do you begin to prepare, and how does a buyer stay on track? Here’s everything you need to know about how to budget for a home.
How to budget for a home: What’s the 28 percent rule?
There’s one number to remember when planning a home budget: 28. The 28 percent rule states that buyers should not spend more than 28 percent of their gross monthly income on their mortgage. This isn’t just a serving suggestion, either. Many traditional lenders will use the 28 percent rule to calculate a mortgage approval.
Don’t forget to use the total mortgage amount for calculations. The entire mortgage amount includes the principal and interest, escrow deposits for taxes, hazard insurance, mortgage insurance premium, and possible additional expenses, such as homeowners’ association fees.
An exception to the 28 percent rule applies to buyers seeking a Federal Housing Administration (FHA) loan. In the case of an FHA mortgage, the U.S. Department of Housing and Urban Development (HUD) will allow a percentage of 31 percent.
What’s a debt-to-income ratio?
A buyer’s debt-to-income ratio (DTI) is the percentage of their gross monthly income used to pay their monthly debt and determines their borrowing risk.
A low DTI ratio shows that the debt and income are balanced. In other words, if a buyer’s DTI ratio is 15%, 15% of their monthly gross income goes towards paying off debt each month. On the other hand, a high DTI ratio can mean that a buyer has too much debt for how much money they make each month.
Borrowers with low debt-to-income ratios usually do an excellent job of making their monthly debt payments. Because of this, banks and other sources of credit want to see low DTI ratios before lending money to someone. Low DTI ratios are preferred because lenders want to ensure borrowers aren’t overextended, which means they have too many debt payments compared to their income.
Here’s an example of how to calculate a DTI:
Mortgage: $1,000
Car loan: $500
Credit cards: $500
Gross income: $6,000
2,000÷$6,000 = .33
This means this buyer’s DTI ratio is 33%.
Fannie Mae recommends that a buyer’s DTI is no higher than 36%. However, the maximum can be exceeded up to 45% if the borrower meets the credit score and reserve requirements in Fannie Mae’s Eligibility Matrix.
Your credit score is not directly affected by your DTI. However, because credit agencies don’t know how much money you make, they can’t figure out what your score should be.
The credit agencies do, however, look at your credit utilization ratio, also known as your debt-to-credit ratio. This compares the total balances on all your credit cards to the total amount of credit you have available, which is the sum of all the credit limits on your cards.
Have you considered all your expenses?
First-time buyers can get caught in the rush of securing their mortgage pre-approval. It’s a significant hurdle to clear, but that isn’t the only recurring expense. Homeowners’ insurance and repairs, maintenance, and monthly utilities will also need to be paid.
Don’t forget about outdoor maintenance, too. For example, will you mow your grass, or do you want to hire someone to do it for you? If you live in an area that receives snow, do you need to buy a snowblower to maintain your driveway?
There may also be additional expenses if a buyer purchases in a master-planned community with homeowners’ association fees.
Remember that all these new expenses must be considered in addition to your regular costs for your vehicle or public transit, clothing, food, and entertainment.
While it’s not a recurring expense, buyers also need to consider the closing costs of their new home. Depending on the state, this amount can vary between 2% and 5% of the purchase price. For example, a home purchased for $600,000 could require between $12,000 and $30,000 in closing costs.
The importance of the down payment
Lenders usually want homebuyers to pay cash for at least 20% of the price. If they can’t come up with that much, they can still get a mortgage, but they often must pay more for private mortgage insurance (PMI).
If they pay PMI, their monthly mortgage payment will increase by 0.5% to 1% of the loan amount, depending on how much they pay.
How much you pay for PMI will depend on the size of the home, your credit score, and how likely the house will go up in value. If you can’t afford to put down $90,000 on a $450,000 home, try to put down at least 10%. Even if you must pay mortgage insurance, your monthly mortgage payment will be less if you put more money down.
The house you buy should also depend on how much you saved for a down payment. For example, if you have enough money to put 20% down on one house but only 10% down on another, the cheaper house will be better.
20% is the conventional amount for a down payment. However, for first-time homebuyers applying for a Federal Housing Administration loan, a down payment can be as low as 3.5% if a buyer qualifies. There are also state-sponsored programs to help with down payments.
Don’t end up house-rich and cash poor
First-time homebuyers who commit to a large, expensive home may have little money in the bank for years after their purchase. Don’t bite off more than you can chew. Instead, crunch the numbers and do the research. When you have a well-planned budget, you’ll be much more confident going into your home purchase, knowing that you can pay for everything involved.
