Donna's smart! It's always better to find out if you can afford
something before you begin seriously shopping. And with low mortgage rates and
home prices going up, many people are wondering if they should buy their first
So how does Donna determine if they can afford to buy? Answers
to a couple of questions can help them decide. First, do they have enough
savings to get into a home? Second, can they afford the regular, ongoing monthly
Let's begin with the first question. How much would it take for
them to get into a home? Affording a home means more than having enough cash for
a down-payment. Initially Donna will need enough savings to cover a
down-payment, the closing costs and some initial expenses like utility deposits.
She'll also need some cash for some of the expenses that come
with a first home. Things like a lawnmower, ladder and basic lawn implements.
Homecenters love first-time homeowners!
Naturally, the down-payment is the biggest item. It usually runs
from 5% to 20% of the price of the home. You can even find some deals with 100%
financing, but Donna can expect to pay higher interest rate if her down-payment
is lower. She probably should plan for about 10%.
Many mortgages have fees or "points" associated with them. It's
not unusual for that to add 2% to the amount that she'd need at closing.
Closing costs vary by locale and by what you negotiate in the
contract. She can use 3% as a guesstimate, but that could be off by as much as
2% depending on the circumstances of her contract. Some places customarily
allocate more expenses to the buyer than other places. Donna should ask someone
in the real estate industry what costs are typically paid by the buyer in her
A few quick calls to the utility companies should give Donna an
idea of any deposits or set-up charges that will be required.
Once Donna has determined if they have enough money to get into
a house, she'll need to figure out if they can afford to hang onto it.
Most experts say that housing expenses shouldn't exceed 35% of
your after-tax, spendable income. Donna can calculate her annual after tax
income using her payroll check information. In fact, unless she got a large IRS
refund or had to write a large check last April, she probably can use the net
figure from her paycheck. All she needs to do is to figure out how many
paychecks she'll get in a year and then multiply her after-tax pay by that
Another benchmark that some advisers use is to total all debts
and then compare that to income. The reason is simple. The part of her paycheck
that Donna has already committed to car payments or credit card minimums is not
available to pay the mortgage. Typically experts suggest keeping total debt
payments to less than 40% of Donna's income. If her estimate of a mortgage added
to her existing payments exceeds 40%, she might be wise to try to pay down some
debt before she begins house hunting.
There's another more accurate way to gauge Donna's ability to
handle the monthly expenses. That's to create a "make believe" budget that
included a house payment. She would take her current budget and just replace her
renter's expenses with the mortgage payment and other homeowner's expenses.
Don't forget to include taxes, insurance and some money each month for home
If Donna is close but can't quite get the numbers to work, she
could check out some lower cost alternatives. Foreclosures or "handyman's
specials" could offer an opportunity. She might also want to consider buying a
duplex and renting one side while living in the other.
Finally, if she does decide to buy, Donna will want to check her
credit report before she begins shopping. That will give her an idea of how
she'll look to a mortgage company. A FICO score of over 700 should put her in
good shape. She'll be able to find a mortgage with a score in the 600's or even
500's, but the interest rate will be higher.
She should also check her credit report for errors. About 25% of
all credit reports contain an error significant enough to effect the interest
rate on a mortgage. If Donna finds an error she'll want to get it corrected
before she begins shopping for a home or a mortgage.
Gary Foreman is a former financial planner who currently edits The
Dollar Stretcher website
and newsletters. Copyright The Dollar Stretcher, Inc.