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1) Planning

How Much Home Can You Afford?

Many lenders will talk of affordability in terms of a percentage of your gross monthly income (GMI) or X times your annual income. For example, you may have read that conventional loans typically allow you to spend 28% to 36% of your GMI. Or maybe some other source said "about 2.5 times your annual income." But if you are going to be a smart shopper, you need to get more specific about how your current income, debt, and expenses affect your home-buying power.

To determine how much you can afford to spend on a home, you have to consider your entire financial situation. Because so many lenders talk about mortgage affordability in terms of a percentage of your gross monthly income, we're going to talk about that also. But always remember this very important point: a monthly mortgage payment does not buy you a house or condo, it buys you a lump sum of cash—your loan—and usually includes money for other expenses such as property taxes and insurance. So to determine your price range of affordable home prices, get out your financial records, your calculator, and your pencil. Use the Income and Expenses Worksheet to help you work through all the figures.

Before you begin remember that your monthly housing expenses will consist of the PITI (Principal, Interest, Taxes and Insurance), and possibly Private Mortgage Insurance (PMI), plus utilities and maintenance.

Wait! What are all those things?

PITI is your monthly mortgage payment. Its components are:

  • Principal—this portion reduces the remaining balance of the mortgage.
  • Interest—this is the borrowing fee.
  • Taxes—this portion goes into the escrow account to pay the annual property taxes.
  • Insurance—this portion goes into the escrow account to pay the hazard insurance (also called homeowner's insurance). Not all lenders escrow your hazard insurance.

Private mortgage insurance, is usually required by lenders when your down payment is less than 20%. This protects the lender against loss if you don't make your mortgage payments. If PMI is required, then it is also part of your mortgage payment and also goes into the escrow account.

Utilities are the bills for electricity, gas, water, sewer, and telephone. You may also want to consider cable/satellite TV as well as your ISP (internet service provider) to be utilities.

Maintenance covers any routine upkeep of the house and yard plus any repairs.

Note that there may be one additional monthly expense. If you buy a condominium, there is usually a condo fee that covers the maintenance and repair of the common areas and other expenses. Or if you choose a neighborhood or development with certain amenities or services there may be a homeowner's association fee.

Down payment

A down payment is the money you use to lower the amount due on a purchase.

Do you need a down payment? If so, how much should it be?

The minimum down payment required will be determined by your lender and the type of mortgage you get. A VA loan doesn't require a down payment, and some lenders offer down-payment assistance programs or 100% financing options. Other loans range from 3% to 20% of the purchase price. The larger the down payment, the smaller the loan. Thus a lower monthly mortgage payment and less interest paid over the life of the loan.

Get pre-approved for a mortgage

Getting pre-approved for a mortgage is the most accurate way to find out what price range of homes will fit your budget. For more information about pre-approval with your credit union, read Chapter 3 of the Information Edge Mortgage Guide.

Next: Is There a Best Time to Buy?

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