Is your home search filtered by list price? If so, you could miss out on your dream home by setting this cap without considering your complete homebuying budget. While establishing a clear budget is an obvious first step when buying a home, it isn’t as simple as you might think. In fact, depending on your cash position, there may be levers you can pull to increase your purchasing power beyond what you would expect. Let’s start with the fundamentals.
The sum of the Principal, Interest, Taxes and Insurance (PITI) you’ll pay each month represents your monthly housing cost. PITI is commonly used in online house affordability calculators and mortgage eligibility estimators; however, those sometimes leave out a critical piece of the puzzle: recurring debt. For a conventional loan, your PITI payment typically should not exceed 28 percent of your household’s gross (pre-tax) monthly income, and your total monthly debt payments should not exceed 36 percent of your gross monthly income. This is known as the 28/36 rule. FHA loans are less stringent at a 31/43 ratio, while more financially conservative borrower might prefer to keep their debt-to-income lower than these recommendations. Regardless of the ratio you use, PITI is a better budgeting tool rather than maximum home price – here’s why.
Establishing a budget around the maximum monthly PITI payment you can afford and feel comfortable with is far better than setting a cap on the home price because taxes can vary considerably in different areas. For example, if your PITI maximum is $2200, you have little recurring debt, and we assume an interest rate of three percent*, homeowners insurance of $100 per month and a 20 percent down payment, you could afford a home up to $523,793 in an area with annual taxes of $4000, or $424,964 in an area with annual taxes of $8000. That’s a $98,829 difference!
So, how does your budget become flexible, you ask? Well, that depends on your cash position. Let’s continue with our scenario above. Say the home you love is priced $536,000 in an area with $4000 in annual taxes. Since you can only afford up to $523,793 per your PITI maximum, you’ll need to boost your purchasing power. One way to do so is by paying “points.” One point typically = one quarter of a percent reduction in your interest rate. By paying one point on your mortgage and reducing your rate from three percent to 2.75 percent, the maximum purchase price you can now afford is $540,928 in our scenario. One point typically costs $1,000 per $100,000, so in this scenario, one point would cost $5,238.
A second option to afford the home you want is to simply increase your down payment amount. In our scenario, you would need to increase your down payment to ~22 percent, or $12,207, to reach the desired loan amount.
An experience mortgage banker who understands the local market is best suited to advise you on your homebuying budget. To learn more about loan types and options, read our 20-page Guide to Happy Homebuying.
*Interest rates are for example purposes only. In this PITI scenario, debt must be less than $2828 or an additional $628 over the monthly PITI payment.
Topics: Budgeting to Buy a Home