July 19, 2008

How expensive of a home should you shop for?

I have a friend who is shopping for a home right now. One of the first big things you ought to do when shopping for a home is to set your home budget. You don't want to go looking for homes without knowing how much you can afford. You should also get prequalified for a mortgage so you know you've got your loan all setup in advance.

So a big question to answer is : exactly how expensive of a home should you buy??

Here's my short 'rule of thumb' answer: Your gross annual salary x 2.5 + your down payment

So for example if you make $60,000 a year and you've got $20k saved for a down payment then shop for a house that costs $170k or less.

How do I get to the salary x 3 figure? Basically I start with 25% of your gross salary as the amount you should spend on your monthly payment. I use 25% of gross salary as a conservative amount since I think its important not to get in over your head with a home loan that is stretching your budget too thin. So if X is your salary that gives us :

x * 0.25

Then I divide that by 12 to figure the monthly payment.

x * 0.25 / 12 or x / 48

Then I estimate the amount of home you can buy with a given monthly payment. Since the interest rate, insurance and property tax amounts aren't fixed we have to ballpark this value. I used a mortgage calculator and came up with ranges in the neighborhood of $105 to $135.

So the amount you can borrow would be in the range of x / 48 * $150 to x/48 * $135 or x *2.1875 to 2.8125

I picked 2.5 to fall within that range.

To figure a more exact amount: Start with your monthly payment budget by using 25% of your gross salary. Then you'll need to figure out exactly how much loan that will get you. First you need to know the interest rate for a loan. Today 30 year fixed loans are going for 6.0 to 6.5% range. But the rates go up and down on a daily basis. Second you should have an idea of the property tax rates in the area as a percent of property value. Third find out what insurance will run in your area. Once you know the loan rate, tax rate and insurance rate you can use a mortgage calculator to find out how much of a loan you can afford given your monthly payment budget.

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