How Much Home Can You Afford?
In order to purchase a home, you need to meet three primary financial requirements:
- You must have a certain amount of money up-front to close on the loan (including the down payment and closing costs).
- You must be able to pay monthly housing expenses.
- You must be able to qualify for a mortgage.
The next step is figuring out how much home you can afford. The rule of thumb used to estimate the maximum purchase price of a home that you can afford is between two times and two and one-half times your gross annual income, depending upon mortgage interest rates. Lower interest rates allow you to buy a home with a higher purchase price. We’ve developed a handy mortgage calculator for your use in determining how much home you can afford. Use our How much can I borrow? tool to help you estimate.
Housing Expense Ratio
Lenders have a method to determine if you qualify for a mortgage. A certain percentage of your total gross monthly income (your income before taxes) is allowed to pay for your total housing debt. These percentages are often referred to as ratios. Your housing debt consists of the cost of principal and interest to repay the mortgage loan, the real estate taxes, private mortgage insurance (PMI) and homeowners insurance. This is also known as PITI – Principal, Interest, Taxes and Insurance. A general rule of thumb places this ratio at about 30% of your total gross monthly household income. This percentage is known as the housing expense ratio.
The bank allows you to apply a certain percentage of your total gross monthly income for other debts. There is a limit to the amount of gross income that you can apply to these other debts, which are also known as recurring debts. A recurring debt is any payment you make on an ongoing basis and includes all loans (even student loans), credit card payments, alimony, etc. Generally, your total monthly recurring debt plus total monthly housing debt can be no more than 40% of your total gross monthly household income for most mortgage loans. This percentage is known as your debt-to-income ratio.
Purchasing your first home will require a cash outlay for your down payment and closing costs. Down payment requirements differ depending on the mortgage product you choose. HSBC Bank USA, N.A. offers affordable housing programs that allow you to put as little as 3% down payment on your new home.
You will need to have saved money for other aspects of the home purchase as well. You will also need money for other closing costs. Your closing costs will vary depending on geographic location of the property and various legal and filing fees. Therefore, your actual costs may differ. This is cash that you will need at closing. For more information on closing costs, please refer to the section regarding Closing on Your Home.
You may receive a gift to be applied toward your down payment and closing costs from an immediate relative (parent or sibling). These funds must be a gift that you do not have to repay. Even if you receive a gift, part of the down payment must come from your own savings.
Evaluating Your Mortgage Loan Options
The two most common types of mortgages are fixed rate and adjustable rate. A fixed rate mortgage ensures that your monthly principal and interest payment will be the same throughout the life of the loan. This is because the interest rate stays the same for the entire term of the loan. An adjustable rate mortgage (ARM) offers the advantage of an initially lower interest rate. Changes in the interest rate at the predetermined change date will depend upon the state of the economy, since the adjustments are tied to an index (such as one-year London Interbank Offered Rate, or more commonly referred to as LIBOR) that change based upon economic factors. The three factors that will influence your monthly mortgage payment in an ARM at each change date are the index, the margin and the number of years to the maturity date. You may be surprised at how a change in the interest rate at the adjustment date of an ARM can change your monthly payment. HSBC Bank USA, N.A. offers a variety of products designed to fit any mortgage need.
In shopping for a mortgage you want to be concerned about the length of the mortgage (term) and the interest rate. Typically, mortgage lenders offer terms of 10, 15, 25 or 30 years. As the term increases, the payment of the loan is spread out over a longer period of time. The result is smaller monthly payments. Keep in mind that shorter terms usually have lower interest rates. You can get a general idea of the amount of your monthly principal and interest payments for fixed rate mortgages using our handy mortgage calculator, How much will my payments be? Remember, this calculates your principal and interest payment; you must add taxes, homeowners insurance and if applicable, Private Mortgage Insurance (PMI) to this calculation to determine your monthly mortgage payment.
You should not just compare lender interest rates. Instead, compare the annual percentage rates (APR). The APR takes into account both the interest rate and the fees a lender will charge. All of these factors will determine how much you will eventually spend to buy your own home.