“If you fail to plan, you’re planning to fail.” – Benjamin Franklin
Americans are an optimistic bunch. Consider a recent study from Bank of The West that found 85% of millennials are confident they’ll achieve the American Dream, of which owning a home is a big piece. Yet more than half of those surveyed don’t have a plan to actually get there, and once they start on the path, are often shocked at how much it costs. Not surprisingly, 68% reported buyer’s remorse, wishing they had been more prepared going into the purchase.
The last thing you want to do is jump into a home loan that’s too expensive for your budget, even if you can find a lender willing to underwrite the mortgage.
What You Should Consider
- The 28/36 Rule
Lenders generally use the 28/36 rule when considering a conventional loan. The 28/36 rule states that a household should spend no more than 28% of its gross monthly income on total housing costs, and no more than 36% on all debt which includes total housing costs plus other recurring debt payments.
The first part of the 28/36 rule requires your front-end ratio to be no more than 28%. The front-end ratio equals your monthly housing costs divided by your gross monthly income. Monthly housing costs, or PITI, include:
- The principal and interest portion of your mortgage payment
- Property taxes, and
- Property and hazard insurance.
The second part of the 28/36 rule requires your back-end ratio to be no more than 36%. The back-end ratio equals your monthly housing costs (PITI) plus your other monthly debt payments (car loans, student loans, credit cards, etc.), divided by your gross monthly income. Where applicable, the back-end ratio also includes required child support or alimony payments.
Example: Add together the amount you and your spouse earn per month (before taxes) to determine your gross monthly income. Let’s say each of you earn $5,000.
Multiply your combined income by 0.28 to determine the maximum monthly housing costs (PITI) you can afford. In this example, you’d multiply $10,000 by 0.28 to get $2,800, which means you can afford up to $2,800 per month based on the front-end ratio.
Next, determine your and your spouse’s total monthly non-housing debt payments, such as car loans, student loans, credit cards, and alimony and child support. For this exercise, we’ll assume you and your spouse pay $1,000 in total monthly non-housing debt payments. Multiply your gross monthly income by 0.36 to determine the total monthly debt payments you can afford, including your mortgage payment and non-housing debt payments. Following the example, you’d multiply $10,000 by 0.36 to get $3,600, which means you can afford up to $3,600 per month in total debt payments.
Subtract your monthly non-housing debt payments from your result to determine the maximum monthly mortgage payment you can afford based on the back-end debt-to-income ratio. In this example, subtract $1,000 from $3,600 to get a $2,600 maximum monthly mortgage payment.
The $2,600 back-end ratio mortgage payment is the lower payment of your two ratios, which means you can afford up to $2,600 for a total monthly mortgage payment.
2. Property Taxes
Counties in California collect an average of 0.74% of a property’s assessed fair market value as property tax per year. Based on the median price of $ 830,000 reported for the San Francisco Bay Area in March 2019, the annual property tax payment would be $6,142, or $511/month. (For county-specific average property taxes click here).
3. Property Insurance
According to a 2018 study by Insurance.com, average home insurance costs vary widely from state to state. Generally, you can expect to pay roughly $3.50 for every $1,000 of property value. For a median home price of $830,000, insurance payments would total $242/month (for a comprehensive look at property insurance click here).
If you are purchasing a condo, property insurance is typically covered under a master policy which homeowners pay along with homeowner association (HOA) dues. It is essential you review the HOA’s financial documents and by-laws to ascertain coverage.
4. Other Recurring Costs
-
- Private Mortgage Insurance (PMI): If you put down less than 20%, your lender will most likely require you to buy insurance from a PMI company. PMI protects lenders from the risk of default and allows buyers who cannot make a significant down payment – or those who choose not to – to obtain mortgage financing at affordable rates. PMI typically costs between 0.5% to 1% of the loan amount on an annual basis.
- Maintenance: According to the Harvard University Joint Center on Housing Studies, you should plan on paying 1% to 2% (annually) of the value of your home in maintenance and upkeep. If you’re purchasing a condo, general maintenance costs are usually covered by HOA dues. However, make sure your HOA has adequate reserves for large-scale maintenance projects such as roof replacement, exterior paint, access-road maintenance, and wood rot and siding repairs.
