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A lot of people who are interested in buying a house get stuck when they come to the point: “I want to buy a new house. How much can I afford?“

Do you know how much you can afford on a home?  Do you know how to determine how much you can afford? 

There are actually two components to figuring out how much you can afford.  First of all, you need to  know how much money you can afford to pay at closing.  This will consist of two parts:  the down payment, and the closing costs.

The down payment is what you will actually pay towards the purchase price of the home.  In the current credit environment, it is unlikely that you can get a 0% down loan unless you qualify for VA benefits.  The lender will want to see that you have some of your own money invested in the home so you will be less likely to default on the loan.

Closing costs consist of various fees and expenses involved in the purchase transaction.  Many of the closing costs are fees charged by the lender.  There are also title insurance, escrow or attorney fees, taxes and transfer fees.  But can you get someone else to pay your closing costs?

You may be able to get the seller to pay many of the closing costs, but the down payment is something you will have to come up with on your own.

The best way to reduce the amount of down payment required is to get  a VA or FHA backed loan.  These are loans that are guaranteed by a government agency.  FHA (Federal Housing Administration) loans currently require a 3.5% down payment.  VA (Veterans Administration) loans require no down payment, but you must be  a veteran of the armed forces to qualify. 

If you can’t qualify for an FHA or VA loan you will probably have to put down at least 10% of the purchase price.  This will normally have to be money that you have in the bank and can demonstrate that you have been saving it for some time.  They call this a seasoned down payment.  Otherwise the lender will want to see documentation of where the money came from. 

It can be a gift from a family member, but the donor will have to fill out documentation that it is a gift and doesn’t have to be repaid.

So the amount of money you have available for a down payment and closing costs will be one factor in determining how much you can afford.

The second factor is how much you can afford to pay monthly for your housing expenses.   Many mortgage brokers and loan officers will tell you that you can afford to spend 28 to 31 percent of your monthly income (depending on the type of loan). This is the figure that the loan underwriter uses to determine if you qualify for the loan.

The underwriters will also want to see that your total monthly obligations (including the mortgage you are applying for,  credit card payments, student loans, car loans, etc.) comes to less than 36 to 41 percent.  Again this depends on the type of loan, with VA having the loosest requirements.

These are general guidelines that lenders use to determine if you qualify for a loan.  Documentation of income for the past two years will be required.  Six months reserves may also be required if your documented income is irregular. 

Exceptions may be made if you can document  why you will be able to afford more.

These guidelines are what lenders use to determine if someone can afford to pay back a loan, but ultimately you must decide if you can  or can’t afford to make the monthly payment.  Nobody else can determine your long term financial goals and you may have expenses or income that are not normally considered by the lender.

So when you say to yourself “I want to buy a new house. How much can I afford?“, you should consider things like saving for retirement, children or caring for a sick relative if these are things important to you.  

Of course, I can’t mention all the things people may want to allocate money for, so if you reserve _____ of your income for _____ you will have to fill in the blanks yourself.    For example, you may want to reserve 15% of your income to make sure Aunt Sadie’s 12 cats continue to live in the style they are accustomed to after her passing. 

If you need help determining your financial objectives, a budget is a good place to start.  And  Money Tree budgeting software is a good way to get started creating a budget.  Click here to get more information about Money Tree.