Unless you’re buying entirely with cash, you’ll be leveraging funds from a lender in order to make your purchase. To decide what you can afford, you might begin with a feeling or perception, such as “I don’t want to spend more than $500,000.” But don’t stop there; that perception may not reflect these critical factors:
- your down payment amount (which affects financing options)
- the monthly PITI payment (cost of the loan plus taxes and insurance, and perhaps )
- the after-tax cost of owning compared with the cost of renting a comparable home (given the property type and location)
- the ratio of actual sale prices as compared to the listing prices in the current market
These factors, in the context of the current market, help you determine the actual purchase price you can afford—and should be prepared to spend.
When pursuing financing for a home purchase, what you contribute of your own funds will affect the array of loan products available to you. (Your credit score and debt and asset levels are key as well.)
Generally, the more of your own money that you “put down,” the better loan terms you’ll have in terms of interest rate and other features.
One key feature is private mortgage insurance (PMI)—and whether you can avoid the sting of it. If having a larger down payment helps you avoid monthly PMI payments and a lower interest rate, that may be worth the investment.
The cost of a PMI premium (depending on the borrower’s credit score and down payment, and the insurer) can range from $30 to $70 for every $100,000 borrowed. If you’re buying a $500,000 home with 10% ($50,000) down, your loan amount will be $450,000. The PMI could then cost $135 to $315 per month.
But if you can afford to avoid or repackage a monthly PMI expense, you can effectively afford more house. Quick-and-dirty loan math: With interest rates in the 4% range, if every $10,000 costs about $50/month in mortgage payments, then saving $200 from would-be PMI payments affords you $40,000 more in purchase price.
So it may make sense to factor in gift funds from family if that would help mount you into more attractive loan products and avoid PMI .
(Principal + interest; taxes; insurance; and condo fee)
I like to remind buyers that if they’re buying with financing, they’re not “paying” $500,000 for a place. The up-front cost to them is the down payment plus closing costs.
Beyond that, they own property on which they’ll gradually build equity by paying down the mortgage over time. Ideally they pay off what remains of the mortgage when they sell the property.
So the monthly payments just need to make sense for daily living. And when you strike the right monthly number that works for your housing budget, then you back into a purchase price from there. Or as some real estate experts say, “you don’t live in the purchase price, you live in the payment.”
So let’s look at monthly costs your lender will factor in:
- PITI + C payment
- principal + interest: based on a given interest rate: ask your loan officer what number to use, given your down payment amount
- condo fee (if it applies)
Owning vs. cost of renting
Consider two questions:
What would it cost to rent something equivalent to what you’re considering buying? Particularly if your current rent is on the rise, or if moving into an improved rental (in terms of location or amenities) would result in higher rent, that’s the cost of your comparison.
Let’s say you pay $2,500 for a two-bedroom apartment with parking, in-unit laundry, a dishwasher, and central air.
What would it cost per month to have what you’re looking for (improved location and/or amenities) as a homeowner, after taxes? Because you’ll be able to deduct the mortgage interest you pay in your monthly mortgage payments (according to your tax bracket), the the post-tax amount is what you want to compare to the rent.
Owning of course also brings benefits that don’t come with renting: the ability to build equity over time as you pay down the mortgage from your monthly payments and the relative control of remaining the property or renting it out to cover its costs.
This calculation helps you get clear about why you’re moving, and what it’s worth to you. Why do you need to buy? For whatever reason you need or want to buy, is the trade in location, amenities, control and the ability to build equity worth that trade?
If you can get the benefits of what you want at or near the monthly cost of renting, then it may make sense to buy. You take that monthly amount that you know you can afford, and back into a purchase price from there.
Purchase vs. listing prices: What are homes selling for?
Are homes selling at, below, or above their listing price? If above listing, be sure to adjust your property search to reflect that.
That is, if homes in a given location are selling at 10% above list price, you’ll need to look at listings priced at least 10% below your max to give you room to compete with other buyers at that market value. So if $500,000 is your ideal price, you’ll likely need to target homes priced at $450,000 and below.
Know this: a listing price is a marketing device. So if priced appropriately, a listing should attract willing, able, and ready buyers.
That said, the listing price (what the seller chose to market the property at) is not the market value. You, the prospective buyer—along with other competing buyers in the market—determine the market value. You determine what it will actually sell for.
What a home is worth is the price a buyer is willing and able to purchase and close on the property for, at given point in time.
So if there are many buyers attempting to buy the same type of property at once and there aren’t enough homes for sale to satisfy that pool of buyers, any given listing is likely to get strong enough attention from buyers that it may sell at or above a listing price. (This might indicate a seller’s market.)
Conversely, if there are many more properties of a type than there are buyers willing able to buy, those listings may lay in wait and may not fetch a price at or above the listing price. (This might indicate a buyer’s market.)