The overview presented a general rule of thumb to decide how much home you can afford, and now it’s time to accurately budget. Lenders generally follow two simple ratios to determine the size of mortgage you qualify for:
Payment-to-income ratio – monthly housing costs should not exceed 26 percent of your gross annual household income.
Debt-to-income ratio – Monthly debt should be less than 36 percent of gross monthly income. This includes mortgage as well as other debts such as credit card payments and car loans.
What lenders are looking for:
- job security
- income stability
- credit score
- amount of debt and size of debt payments
- if debts are paid late or if there are penalties or bankruptcy
- whether income will be stable enough to pay the loan
- if there are any salary increases expected
- if there are plans on having a child, and if so, whether income can support the additional costs
To calculate how much home you can afford you can try out Zillow's Affordability Calculator, which is easy to use and offers results based on both aggressive and conservative estimates. Alternatively, you can do a search for "mortgage affordability calculator" and you'll find plenty to choose from. For Canadians, “Are you Financially Ready” is a complete resource featuring a home affordability calculator and other budgeting tools.
Costs of buying a home
Be prepared for a bunch of upfront costs when buying a home. Even if opting for a low down payment of 5 percent you’ll still have to fork out several thousand dollars between home inspection fees to title insurance before you get the keys to the house. And after unlocking the door to your new home you still face a number of other costs such as gardening equipment, decorations, repairs and moving expenses.
Use this home purchase cost estimate worksheet to sort out what you’ll need to pay and plan accordingly. If you want to add sustainability modifications, such as solar panels or a composting toilet, to your home, remember to add those in to your total home cost on the worksheet. Though buying a home is expensive, you may qualify for rebates (and green homes qualify for even more rebates than conventional homes).
Tax rebates and incentives
Database of State Incentives for Renewables & Efficiency (DSIRE) maintains a comprehensive listing of various incentives, including tax credits, grants, loans, rebates and more. Though incentives are neatly organized according to state, they also have a page that lists federal benefits. In addition to green-home specific incentives, check out the Department of Housing and Urban Development for FHA loans and special homebuying programs available on the federal level and visit Homes&Communities for a listing of homebuying programs available on the state and local levels. It's also worth checking out Fannie Mae and searching around the web for more possibilities to save.
In Canada the federal government’s Home Buyers’ Plan lets you withdraw up to $25,000 from your RRSP to buy or build a home, which gives you 15 years to repay that amount tax-free. Visit the Canada Revenue Agency for more details. When purchasing an energy-efficient home you could also qualify for a 10 percent mortgage loan insurance premium refund and extended amortization (if using CMHC-insured financing). Visit CMHC Green Home for more details. As well, the NRCan Office of Energy Efficiency’s Financial Assistance page offers additional energy-efficiency incentives.
What to do if you can’t afford a home?
If after running through the previous exercises you’ve found that you cannot afford a home, or cannot afford the type of home you want, you have a few options:
- Improve your financial position by saving up, spending less and paying off loans.
- Lower your expectations in a home or look at a cheaper location to live.
- Buy a larger home than your needs dictate (if you can finance it securely) and rent out a part of it to help pay the mortgage and expenses.
- Buy a home as an income property while you rent (or live with family) to save up to buy the home you desire.
- Build your own home or take part in a program in which you can assist in the building.
Assess your credit
Before lenders will approve your mortgage they’ll check your credit history to determine how you’ve used credit in the past and if you’re a risk to them or not. Request a copy of your credit report from one of the leading credit-reporting agencies, such as TransUnion or Equifax. You can request a free credit report online or by calling 1-877-322-8228 in the U.S. In Canada a small fee will be charged for this service.
If you’re in no rush to buy, it’s a wise idea to improve your credit rating in advance of buying a home so that when the time comes to buy, lenders will look more favourably upon you.
If you have no credit rating at all, you can establish a rating by getting a credit card, making some small purchases then paying them off immediately upon receiving the monthly statement.
If you have poor credit, it’s worth talking to a credit counsellor. The Credit Counselling Society offers free credit counselling, bankruptcy and debt consolidation help via phone or online chat. Give them a call at 1-888-527-8999 or visit them online at nomoredebts.org. The good news is that most negative credit history, even bankruptcy, falls off your file after seven years.
Apply for pre-approval
A pre-approval is a commitment from a lender that you qualify for a loan of a particular amount. By taking this step you’ll know how much you can afford before you go through the process of buying a home. Pre-approvals also prove useful in a competitive market because seller's won't take an offer as seriously from a buyer who has not been pre-approved as from one who has.
Contact your bank or mortgage broker for pre-approval. Decide what kind of mortgage you want (i.e. open or closed). Make sure you do a full needs-analysis with your lender to figure out what’s right for you. When meeting for a pre-approval, bring your personal documentation and proof of salary, assets and debts with you.
Once pre-approved you’ll receive a limited-time written confirmation, approving you for a fixed interest rate, which takes the guesswork out of this stage of the homebuying process. With this knowledge in hand you'll be confident knowing what price range you can buy in and knowing that you won't miss out on your dream home just because you didn't get pre-approval.
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