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HOW MUCH HOUSE CAN I AFFORD?
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Step 1 when home shopping is to determine your budget. Many people aren’t sure how much home they can afford. A good rule of thumb is the 28%/36% rule, which states that you should not spend more than 28% of your gross (before tax) monthly income on home-related costs and no more than 36% on total debts, including mortgage, credit cards, and other loans such as auto or student loans. For example, if your household earns $10,000 a month, and you are already paying $1,500 in car and student loan payments, your house costs should not exceed $2,100 a month.
Once you have a rough budget in mind, it is important to work with a lender to get pre-approved for a home loan in that budget. Pre-approval letters are crucial to make sure your offers are taken seriously by sellers. Lenders will take many factors into account when determining your approved loan amount including credit score, sources of income, and debt-to-income ratios. This is just a starting point—there are many other factors to consider when deciding how much you want to spend on a home. Take into account your entire financial situation when considering how much house you can afford. Do you have certain savings goals? Do you want to reserve funds for travel? Will you be paying for private school or college tuitions? You may not want to spend the full amount you are approved for—make sure you are working within a budget that allows you ample room to live the life you want and avoid becoming “house poor.”
Lastly, make sure you have the cash funds available for the down payment and closing costs associated with your home purchase. For a breakdown in the costs you can expect when purchasing a home, read on below.
Costs to Purchase a Home
The costs of home ownership go far beyond the price tag of the house itself. It is important to know all of the costs involved when purchasing and owning a home so that you understand fully what you are committing to. Here is a recap of the most common costs you will incur when buying a home:
Earnest Money + Option Fee
When you submit an offer to purchase a house and the seller has accepted, you will immediately have to hand over a check for earnest money and a check for the option fee. Earnest money is a deposit held by the title company until closing as a sign of good faith intensions to fully execute the contract. It is generally 1% of the purchase price of the home and, as long as you do not default on the contract, will be credited towards the purchase at closing. An option fee is money paid directly to the seller for an option period, a specified number of days which allows the buyer to terminate the contract for any reason. It is during this option period you will have inspections performed on the property. The option fee and number of days in the option period is negotiable, but generally under $1000. The seller gets to keep the option fee in the event you terminate the contract but can choose to credit the money back to you if the transaction closes.
Inspections
The period between submitting an offer and closing the real estate transaction gives you the time to perform certain inspections on the home and to secure financing. The costs of inspections will vary depending on the type of inspection, the square footage, and the age of the home, but expect anywhere between $250-$1000 per inspection on average. Most homebuyers perform a general home inspection that will include the structure, roof, walls, doors, windows, ceilings, attic area, insulation, heating and cooling systems, ducts and vents, water heater, plumbing system, drain system, water supply system, gas supply, fireplace, concrete flatwork, electrical system, appliances, and sprinkler system. But there are additional inspections you may want to perform. For instance, Houston is a humid, wet climate and many homeowners have issues with stucco allowing moisture into the structure of the home. If you are considering a stucco home, you may want to hire a specialized stucco inspector. We can help advise on what types of inspections you should perform and provide referrals to well respected inspection companies.
Down Payment
When you are financing the purchase of a home (rather than paying cash in full), most lenders will require some sort of down payment. While the traditional amount is 20% of the purchase price, it is possible to get loans with less money upfront. Be aware that a lower down payment upfront often means an increased cost of borrowing and higher monthly payments, so be sure to weigh the pros and cons of putting less money down. You may wish to put less up front, regardless of higher monthly payments, so that you can reserve some of your financial resources for move-in expenses or renovations that may need to be done to the property.
Closing Costs
Closing costs include fees that a lender charges to process the loan (origination fees, points), administrative fees (credit reports, document/deed prep, recording fees), lender required appraisal and inspection costs, costs to obtain the survey on the property, and the costs associated with pulling, transferring, and insuring the title to the property. There may also be certain prepaid payments due at closing that include homeowner’s insurance premiums, prepaid interest charges, and any payments you will be holding with your lender in escrow (taxes and insurance payments). The amount you will pay in closing costs varies depending on your specific transaction, but generally fall within 2-5% of the purchase price. Some lenders have lower fees than others, so it is important to shop around. If you are unsure where to start, we will gladly refer you to a few lenders we know and trust. As you search for lenders, you will receive a loan estimate from each that will outline their closing costs so you can compare and find the best deal for you. Remember that some of the costs and fees are negotiable. We will help you review loan estimates to understand which costs are negotiable.
Ongoing Homeowner Expenses
Mortgage Payments
This is the most predictable cost associated with buying a home. Once you select a lender and settle on an interest rate, you will know exactly how much you will be paying each month (if you are choosing a fixed rate loan, adjustable rate loans are also common, but you will have some length of time with predictable payments). Your monthly mortgage payments will include a portion that will go towards repayment of the loan (the principle) and a portion that pays for the interest charge on the loan.
Property Taxes
Tax rates will vary depending on where the house is located. As your real estate advisors, we will give you a rundown of what you can expect to pay in taxes for each potential home you are considering. However, tax rates fluctuate over time, so this is one of the least predictable costs of home ownership. In addition to rate increases, because taxes are levied as a percentage of your home value, your taxes will also increase as the assessed value of your home increases. It is important to carefully review the new assessed value of your home each year as soon as you receive it. You have the opportunity to contest increases in your assessed value, but there is a deadline each year. Feel free to reach out to us if you have questions. We are here to support you in your entire journey as a homeowner!
Homeowner's + Hazard Insurance
Lenders will require some type of homeowner's insurance policy in order for them to agree to lend on the property. The most common type of policy is an HO-3 policy, but your lender of choice will let you know what is required. The average cost of a homeowner’s insurance policy in Houston is between $2500 and $3000 but varies greatly depending on the house and the amount of dwelling coverage, deductible, and liability protection, anywhere between $1,000 and $6,000 a year on average. There are many options, so be sure to shop around. As Houston is a flood prone city, there are certain flood plain areas where lenders will require homeowners to purchase additional flood insurance policies. Flood insurance typically costs between $400 to $2,000 a year. We will advise whether or not the property you are considering is within a flood plain that requires flood insurance. Home insurance premiums are either paid annually directly to the insurance company or paid monthly to your lender as part of your mortgage payments, held in escrow until the premiums are due at which point your lender will pay on your behalf.
Mortgage Insurance
If you are unable to pay a 20% down payment, you will have to pay for private mortgage insurance (PMI), which typically costs between 0.5% to 1% of the entire loan amount on an annual basis. For example, you can expect to pay as much as $1,000 a year ($83.33 a month) on a $100,000 loan, assuming a 1% PMI fee. These premiums protect the lender in the event you default on the loan. The lender may charge an upfront amount (points) as well as premiums due each month. Monthly premiums are lumped in with your mortgage payment until the remaining principal balance on the mortgage dips below 80% of the purchase price. Most lenders automatically cancel your PMI payments once your loan balance reaches 78% of the initial purchase price. However, you have the opportunity to request cancellation of PMI when your loan balance reaches 80% of the purchase price OR if your home value has increased and your loan balance is now 80% of your current home value, so it is important to pay attention to this. Some lenders require your loan balance to be a little lower than 80% if you haven’t done specific improvements, but you can call your lender for more information. Your lender may charge you for a new appraisal to validate the increase in your home value, but it could save you in the long run. For instance, a loan that is scheduled to pay $3,600 in PMI payments a year for the first ten years of the loan can expect to pay $36,000 in mortgage insurance over the life of the loan. If home prices in your area rise dramatically after the first three years, the lender may allow a new appraisal on the property. Let’s say the lender charges $400 for the appraisal and the home appraises for the required amount to cancel PMI payments. The homeowner has saved themselves $24,800 over the life of the loan ($36,000 expected PMI payments - $10,800 paid PMI payments - $400 appraisal fee).
HOA, Co-op, or Condo Fees
If you are buying a property that is part of a homeowner’s association or a condo or co-op, you will probably have additional monthly dues on top of your mortgage payment. The fees pay for shared amenities such as community clubhouse/pools, landscaping, maintenance, security, etc. In some cases, particularly with condos, monthly fees can be almost as much as mortgage payments. Pay careful attention to these costs when comparing potential properties. It is not uncommon for these fees to increase slowly overtime. If substantial building repairs are needed, homeowners could see a jump in dues or an added assessment fee. Do your research on how well the building is maintained, the property’s history, and projected maintenance or remodeling.
Utilities
Utility costs are some of the most obvious but often overlooked factors when looking at potential properties. You may fall in love with a large square footage home, but be careful about getting into more space than you need. The larger the home, the higher those electricity bills will be. Love that large, immaculately landscaped lawn with the sophisticated sprinkler system? Think about how that will affect your water bills. Research the energy efficiency of the homes you are considering. Not only are energy efficient homes good for the environment, they can save you a lot of money in utility expenses. An older, poorly insulated home will have much higher energy costs than a newer or more energy efficient home of the same square footage. Because there are so many factors that go into utility costs, there are no good averages, but it can be helpful to poll people living in homes similar in square footage and age to the ones you are considering to get a ballpark idea of what you can expect.
Maintenance
This can be the biggest headache, especially for first time homeowners. You are now responsible for maintaining your home—everything from landscaping, changing air filters, dealing with plumbing debacles, roof repairs, mold and mildew remediation, appliance repairs, the list goes on! The costs vary wildly from purchasing a $10 air filter to spending $15,000 on a brand-new roof. Many financial advisors recommend saving six months’ worth of expenses as an “emergency fund.” It is a good idea to create an emergency fund for your home as well. Consider saving 1% of your home’s value each year as a long-term household maintenance and repair fund.
Homeowner Costs Example
Below is a rough breakdown of common homeowner costs based on the purchase of a $500,000 single family home in an area with HOA maintenance fees, assuming a 10% down payment and a 30-year fixed loan with a 4% interest rate. It is reflective of one of many scenarios and is not meant to suggest similar cost breakdowns for any specific situations.
Initial Out of Pocket Expenses:
Earnest Money.............................................................................$5,000
Option Fee........................................................................................$250
Inspections......................................................................................$500
Down Payment
(10% - Earnest Money/Option Fee already paid).......$44,750
Closing Costs.............................................................................$10,000
Total Initial Out of Pocket Expenses......................$60,500
Monthly Expenses:
Principle + Interest Mortgage Payments.........................$ 2,148
Property Taxes.............................................................................$1,000
Homeowner's Insurance............................................................$215
Mortgage Insurance.....................................................................$375
HOA Fees.............................................................................................$75
Utilities...............................................................................................$300
Savings for Maintenance/Repairs.........................................$425
Total Monthly Expenses..................................................$4,538