Do you know how much house you can afford?

Wondering how much house you can afford? Try following these simple steps to find out.

Yahoo Homes

Are you thinking of buying a home, but not sure exactly how much home you can afford? It's an important question. After all, there's no return policy on houses. So if you bite off more mortgage than your bank account can chew, it could have a big impact on your life - not to mention your sleep patterns.

"You don't want to be lying awake worrying about your loan payment. We call it the pillow test. If you're up all night worrying about it, you probably bought too much house," says Jim Duffy, a mortgage banker with Cole Taylor Mortgage.

Fortunately, there are ways to make sure you get a good night's sleep under your new roof. So before your dream house turns into an insomnia-inducing nightmare, read on for some tips on figuring out how much house you can afford.

Tip #1: Calculate Your Debt-to-Income Ratio to Make an Educated Estimate

Are you awash in credit card, auto, and personal loan debt, or are you debt-free? It's likely you're somewhere in between. But whatever your financial situation might be, your debt-to-income ratio will be an important factor in determining how much house you can afford.

What is a debt-to-income ratio? Simply, it's how much your total monthly debt is in relation to your gross monthly income. Now let's get into some details.

"Things that are included in the debt-to-income ratio for most people are anything that shows up on your credit report, such as student loan payments, credit card payments, car notes. Also, the mortgage you plan to get will be factored in," says Duffy. He also notes that alimony and child support count as well. Things like groceries, life insurance, and tennis lessons, however, don't count.

So when it comes to deciding how much home - or mortgage - you can afford, your total debt-to-income ratio, including the predicted mortgage payment, should not exceed 40 percent (this threshold can vary from lender to lender).

To fully illustrate this, here's an example. Let's say you and your significant other earn a household income of $8,000 per month. Forty percent of $8,000 is $3,200. So your debt, including your mortgage, should not exceed this amount if you want to qualify for said mortgage. From there, you can figure out how much house you can afford…or at least move onto the next section.

Tip #2: Check Your Credit Score to Predict Your Interest Rate and Monthly Payments

Let's say you figured out your debt-to-income ratio and determined that you can afford a $300,000 loan. That's great, but you'll also have to figure out what your credit score is. If it’s on the lower end, you may be paying more in monthly payments than you imagined.  

[Got a good credit score? Click to compare mortgage rates now.]

For example, on a $300,000 mortgage, here's what your interest rate and payments might look like based on various credit scores, according to myFICO.com*:


FICO Score APR Monthly Payment Total Interest Paid
760-850 3.143 percent $1,288 $163,704
700-759 3.411 percent $1,325 $176,866
680-699 3.588 percent $1,354 $187,504
660-679 3.802 percent $1,390 $200,533
640-659 4.232 percent $1,465 $227,256
620-639 4.778 percent $1,562 $262,208

As you can see, your monthly payments are highly dependent on your credit score, so when determining how much you can afford on your mortgage, make sure to check your credit report.

Tip #3: Factor in Your Private Mortgage Insurance

Private mortgage insurance. It just sounds expensive, doesn't it? And unfortunately, if your down payment is not large enough, private mortgage insurance can be costly and shrink the amount of house you can afford.

First, what it is: Private mortgage insurance, or PMI as it is commonly referred to, is an insurance that protects the lender against you defaulting on your mortgage, according to "A consumer's guide to mortgage refinancings" published by the Financial Reserve Board (FRB). The FRB says lenders usually make you pay PMI when your down payment is below 20 percent.

According to the FRB, the estimated cost of PMI is about $50 to $100 per month. However, Duffy says it can be substantially more since the formula for figuring PMI varies with everything from loan size to loan type, and even how little of a down payment you make. So it can range anywhere from .5 percent of the mortgage amount to 1.5 percent of the mortgage amount - per month.

Let's be conservative and say it's .75 percent on a $375,000 fixed-rate mortgage. That comes out to $234.37 per month tacked onto your monthly payment.  And yes, PMI counts toward your debt-to-income ratio.

The good news, however, is that PMI is not permanent. According to the FRB, once you pay down your loan enough to achieve 20 percent equity in your home (based on the original appraised value), you can simply write a letter to your lender asking for them to cancel the PMI. That's probably the best letter to a bank you'll ever write.

Tip #4: Add in Your Homeowner's Insurance and Property Tax Expenses

We know - more insurance. And taxes are kind of a bummer, too. But it's certainly best to plan for them now rather than calculating them during a bout of stress-induced insomnia.

First, let's talk about homeowner's insurance. According to the FRB, your mortgage lender will require you to carry this insurance. It protects you against physical damage to the house by fire, wind, vandalism, and other causes.

As for the cost of home insurance, the FRB estimates a cost of $3.50 per $1,000 of your home's purchase price. So, for a $375,000 home, it would be about $1,312 annually. Divide that by 12 months - because Duffy says that often this cost is added to your monthly mortgage payment - and it comes to about $109 per month.

Now on to your property taxes. These of course vary widely depending on not only the assessed value of your home, but also the county your home is in, says Duffy. The national average is 1.14 percent of the home's value, according to 2010 figures from the Tax Foundation, a non-partisan tax research group based in Washington, D.C. Their data shows that this can vary anywhere from .27 percent (Hawaii) to 2.01 percent (New Jersey).

So let's use the average of 1.14 percent to see what this might mean for your housing budget. On our $375,000 home, that's $4,275 per year, or about $356 per month.

Based on this example, that's an extra $465 you'll have to add to your monthly mortgage payment for homeowner's insurance and property taxes alone.

* Monthly payments and interest rates were calculated on myFICO.com on April 5, 2013, using their Loan Savings Calculator.

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