How do I know I can afford the house I am about to buy?

2 Nov

Knowing you can afford the house you’re about to buy is essential to prevent financial strain and secure your investment. Here’s a comprehensive guide to help you assess your affordability and approach the purchase with confidence.

1. Calculate Your Budget Based on Income and Expenses

Start by taking a close look at your current income, expenses, and debt obligations to determine how much you can comfortably spend on a mortgage.

Key Ratios to Consider

Debt-to-Income (DTI) Ratio: This ratio helps lenders determine how much of your monthly income goes toward debt payments, including your mortgage. Aim for a DTI ratio below 36%, with no more than 28% of your gross monthly income going to housing expenses (the "front-end" DTI ratio).
Housing Costs as a Percentage of Income: Many financial experts recommend that your housing costs (mortgage, property taxes, insurance, etc.) not exceed 25–30% of your gross monthly income. This helps ensure you have enough income left over for other expenses and savings.

Monthly Expense Breakdown

List all fixed and variable monthly expenses, such as utilities, groceries, transport, and insurance, in addition to existing debt payments. Compare this with your monthly income to get a clear sense of what you can allocate to housing costs without overextending yourself.

2. Evaluate Your Savings and Emergency Fund

Having sufficient savings and an emergency fund is critical when buying a home, as unexpected expenses often arise.

Down Payment: Aim to save at least 10–20% of the property’s purchase price for a down payment. A higher down payment reduces the mortgage amount and monthly payments and can help you avoid paying for private mortgage insurance (PMI) if you reach the 20% mark.
Emergency Fund: Ideally, have an emergency fund covering 3–6 months’ worth of living expenses, separate from your down payment and closing costs. This can help you manage any financial surprises, like sudden repairs or temporary job loss, without compromising your mortgage payments.

3. Factor in Additional Costs Beyond the Mortgage

The purchase price is just the beginning. To avoid financial strain, make sure to budget for other costs associated with buying and owning a home.

Upfront Costs

Closing Costs: Typically ranging from 2–5% of the property’s purchase price, closing costs include fees for appraisal, inspection, legal services, and lender fees. These are often due upon closing, so ensure they’re covered in your budget.
Moving Expenses: Moving can be a significant expense, especially if it involves long distances or requires hiring movers. Plan for any necessary repairs, painting, or initial setup costs for the new home as well.

Ongoing Ownership Costs

Property Taxes: Property taxes vary by location but are often a significant ongoing expense. Check your local tax rates and calculate what this will add to your monthly housing costs.
Home Insurance: Homeowners’ insurance is essential and may be required by your lender. Premiums vary widely depending on the property and location, so get quotes in advance.
Maintenance and Repairs: A general rule is to set aside 1–3% of the property’s value annually for maintenance. Older properties or larger homes may require a higher maintenance budget.
Utilities and Homeowners Association Fees: Utilities and, if applicable, HOA fees can add to monthly costs. Research these costs for your prospective home and ensure they’re included in your budget.

4. Consider Interest Rates and Loan Terms

The mortgage interest rate and loan term significantly impact your monthly payments and the total cost of your home over time.

Interest Rate: Even a slight change in interest rates can affect affordability. Lock in a competitive rate if possible, and explore options with different lenders to ensure you're getting the best terms available.
Loan Term: A 30-year fixed-rate mortgage will have lower monthly payments than a 15-year mortgage, but you’ll pay more interest over the life of the loan. Decide on a term that aligns with your financial goals and monthly budget.

Mortgage Affordability Calculators

Many lenders and financial institutions offer online mortgage calculators. These tools allow you to input income, down payment, interest rate, and loan term to calculate estimated monthly payments and assess affordability.

5. Review Your Credit Score and Financial Standing

Your credit score directly influences the interest rate you'll receive on a mortgage. A higher score means better loan terms and potentially lower monthly payments, which can improve affordability.

Check Your Credit Score: Aim for a score of at least 700 to secure favourable interest rates, though each lender may have different thresholds. If your score needs improvement, consider delaying your purchase to build up your score.
Pay Down High-Interest Debt: Reducing other debts, especially high-interest ones, can improve your DTI ratio and your ability to make mortgage payments comfortably.

6. Get Pre-Approved for a Mortgage

Mortgage pre-approval is an essential step that not only helps you understand how much a lender is willing to loan but also signals to sellers that you’re a serious buyer.

Understand the Pre-Approval Amount: Pre-approval doesn’t obligate you to borrow the maximum amount. Instead, use this figure as a guideline and ensure the monthly payment fits within your comfort zone based on the calculations above.
Be Aware of Conditional Approval: Sometimes, pre-approval is conditional based on factors like a high appraisal or lack of new debt. Discuss these details with your lender to ensure you understand any additional requirements.

7. Test Your New Budget

A good way to test whether you can truly afford the home is to live on your estimated post-purchase budget for a few months before committing. This means setting aside the difference between your current housing costs and what you expect your new mortgage and associated costs to be.

Adjust for Accuracy: This “trial run” can help you identify any areas of overspending or unexpected costs, allowing you to adjust your budget accordingly before you commit.

Final Checklist Before You Buy

Before committing, ensure that:

Your down payment and closing costs are fully covered.
You have a clear idea of your monthly payments and how they fit within your budget.
You’ve factored in all ongoing costs (taxes, insurance, maintenance).
You’re prepared for potential future interest rate increases (if you’re opting for an adjustable-rate mortgage).
You’ve stress-tested your finances to ensure they’re flexible enough to withstand income changes or unexpected expenses.

Conclusion

Buying a home is a major financial commitment, but with careful planning, you can make an informed and comfortable choice. By understanding your budget, accounting for additional expenses, and preparing for changes in income or costs, you’ll set yourself up for a smooth home-buying experience and a sustainable investment.

If you’re uncertain, consider consulting with a financial advisor or mortgage broker to gain clarity on your financial readiness and ensure the home you’re eyeing is affordable.

Craig Nichol