In the first article of this two-part series, we looked at some steps you can take to be financially and emotionally prepared to begin your home search. In this second installment, we'll develop a framework to determine how much you can afford, how lenders view your application, and how much you should finance.
Show Me The Money
Want to figure out how much home you can afford? This can be difficult to nail down with rules of thumb like income multipliers or percentages. A home affordability calculator may be a good place to start, but keep in mind that the output does not capture the nuances of your personal financial situation. It’s best to take a closer look at the actual expenses of home ownership and how they fit into your budget.
It's helpful to look at this in two parts: the cash you’ll need to bring to closing (down payment and closing costs), and the ongoing monthly cost of owning the home.
Cash To Close
If you have a general price range in mind, you can estimate how much cash you’ll need to have on hand to make your purchase. First, consider how much you'll need for a down payment. Many people aim for 20%, but this is often not necessary or feasible. One advantage of a 20% down payment is that it allows you to avoid paying PMI (private mortgage insurance). Though you pay the PMI premiums, this insurance is designed to protect the lender against loss should you default on the loan. This additional ongoing monthly cost can take years to get rid of. Another advantage of a large down payment is that it may help your offer stand out amongst the rest. Buyers with a higher down payment are often viewed as more financially stable, and better equipped to handle financing issues that may arise.
However, you may not have enough cash to cover a 20% down payment, or may not want to tie up so much of your liquid assets in your new home. You may prefer to reserve a chunk of cash for renovations and upgrades, for example. Many loan options allow for a lower down payment. According to a 2020 study by the National Association of Realtors, the average down payment on a first home is 7%. Talk with your realtor and lender about current market conditions and options.
Factor In Closing Costs
Closing costs vary by state, and typically run about 2-6% of the price of the home, which can come as a shock to many first time buyers. Ask any potential lenders for a written estimate of closing costs so you can factor them into your cash need.
When you consider how much cash you need to have on hand, include the anticipated down payment, estimated closing costs, moving costs, and any cash you think you’ll need to make up-front repairs or improvements, and to furnish the home. It’s also important to consider your other cash needs, including reserving 3-6 months worth of cash for your emergency fund.
If you’re in the process of saving for a down payment, and plan to purchase within a few years, it’s generally advisable to keep the funds in a liquid, low-risk account. An FDIC-insured high yield savings account is a safe option.
What About Monthly Costs?
To evaluate the affordability of a home, you'll need to get an estimate of the monthly payment, which is calculated based on the home price, loan term (i.e. 30- or 15-year), and the mortgage interest rate. Interest rates are a moving target, as they fluctuate daily. Your lender can help you get a feel for when it makes sense to "lock" the rate, pay for discount points to lower the rate, etc.
The technically inclined may find this analysis by Ben Carlson of Ritholtz Wealth Management helpful to process the interplay between interest rates, inflation and home prices over time. For a basic illustration of the impact of interest rates on monthly costs, let's compare two 30-year fixed mortgages: mortgage #1 is a loan of $420,000 at 4%, and mortgage #2 is a loan of $475,000 at 3%. The monthly payment (approximately $2,000, not including property tax or insurance) for these loans is almost identical, despite the $55,000 differential in principal.
Assuming you plan to take out a mortgage, lenders will have their say about what they think you can afford. It’s good to do your own assessment, though, to make sure you’re considering how this purchase will fit in with the rest of your budget.
The Lender Says…
Lenders look at financial ratios to determine how big a loan payment they think you can handle. If you have excellent credit, you may be offered a bit more wiggle room on these numbers.
Lenders generally look for a debt-to-income ratio (also known as “back-end ratio”) of no more than 36% - meaning, no more than 36% of your monthly gross income will go toward paying off debt (including mortgage, car loans, student loans, credit card debt, etc). Lenders may also consider the “front-end ratio,” which assumes that you can afford to pay up to 28% of your gross income toward PITI (principal, interest, tax, and insurance). For example, if your gross income is $10,000 a month, the back end ratio assumes that you could pay up to $3,600 toward all debt, and the front-end ratio assumes you can afford $2,800 per month toward PITI.
But My Budget Says..
Keep in mind, though, that the lender is looking at how much mortgage you can afford in the context of other ongoing debt payments. Their goal is to offer you a mortgage payment that they believe you will be able to pay while meeting your other debt obligations, in order to protect themselves from having you default on the loan. They do not, however, look at how much you can pay monthly towards your mortgage while still maintaining your current (or increased) lifestyle spending. If you have high ongoing payments that are not part of your debt picture, such as school tuition for your kids, supporting an elderly parent, or bulking up your retirement accounts, you need to factor that into your own calculations of what you can afford to pay toward your home. There may be a disparity between what the bank would be willing to lend to you, and what you could comfortably pay, particularly if you have little to no other debt.
Hidden Costs of Home Ownership
Create a list or spreadsheet of the items you'll need to factor into anticipated monthly housing costs, and look at how the total compares to what you’re paying now.
Obvious costs to factor into your analysis include PITI – principal, interest, property tax and homeowner's insurance. It’s easy to forget about the cost of maintaining your new home. A rule of thumb is to factor in about 1-2% of the value of the home per year to cover maintenance costs. On a $500,000 home, you’ll want to plan on $5,000-$10,000 per year for maintenance costs. If the home is newly renovated or built, you may need less than 1%; if it’s an older home, maintenance costs may run above 2% . You’ll also want to consider homeowners association or condo fees, as well as increased utility costs, if applicable.
If the estimated monthly costs will be higher than your current housing costs, examine whether you can afford that increase without tightening your belt more than will be comfortable. If you see that you need to make cuts in order to afford the home of your dreams, think about whether you’ll be happy with a reduction in your spending. For example, if you currently spend $300 a week at restaurants, will you be happy if you cut that to $100 to afford your new mortgage? For some the answer is yes, for others, no.
If you’re ready to start looking in earnest, it’s time to apply for loan pre-approval. It’s a good idea to contact at least three lenders to get a feel for their service and fees. Ask your real estate agent, friends and relatives for referrals. Keep in mind that working with an individual has advantages here – while you may find low rates via online lenders, it can be difficult to get consistent service. A mortgage broker can be helpful if you have less than pristine credit or an unusual financial situation. Be sure to ask lenders about any perks for first-time home buyers in your state and/or county.
A mortgage pre-approval shows a seller that you are a serious buyer and that you have the means to back up the offer you make on their home. Keep in mind that it’s fine to get pre-approvals from more than one lender – according to the Consumer Financial Protection Bureau, as long as the credit checks are all made within the span of 45 days, the multiple credit checks will count as only one hard inquiry on your credit report.
If a generous relative is providing funds toward a down payment, you may need to prove that the money is a gift, not a loan, in order to avoid issues during underwriting. If the money has been in your account for under two months, you should be prepared to provide a gift letter to show that the funds don’t need to be paid back.
What if you have enough cash to purchase a home outright? Should you funnel the money into the home, or get a mortgage and use the extra cash to beef up your investments? You may have heard that if the return on invested assets exceeds the mortgage interest rate, you'll come out ahead by getting a mortgage and investing the cash. We'll take a look at an illustration of this concept below.
First, The Math
Let's say you have a windfall of $500,000 and are deciding between paying cash or financing a $500,000 home. We'll look at the mortgage option first: say you put down $100,000, and take out a 30-year fixed mortgage at 3.5% on the remaining $400,000. Your monthly payment (not including taxes or insurance) would be $1,796. Let's also assume that you plan to pay the mortgage out of your income, and you invest the remaining $400,000 of cash in a hypothetical fund that returns 3.5% annually1, leaving it untouched for 30 years. The net result at the end of 30 years is that you own the house, plus invested assets of approximately $1,141,000.
And now for the cash purchase option: in this scenario, you pay $500,000 in cash for the home, and you invest what you would have paid for the monthly mortgage payment ($1,796 per month) in the same hypothetical fund with a 3.5% annual return. The net result is that at the end of 30 years you own the home, and invested assets of approximately $1,141,000. In this illustration, where the the mortgage rate is equal to the rate of return on invested assets, and you have the same cash outlays ($500,000 at the beginning of the period, and $1796 per month for 30 years) you get the same result: a fully paid-off home, plus $1,141,000 of invested assets at the end of 30 years.
Now let's change one variable - the assumed rate of return on invested assets. In this comparison, we'll use an annualized return of 8% on invested assets2. This time, you get a mortgage with the same 3.5% interest rate, but you invest the $400,000 of cash as a lump sum in a fund with a hypothetical 8% annualized return2. Now the net result at the end of 30 years is that you own the house, plus invested assets of approximately $4,374,000.
And if you pay cash for the house and invest the $1,796 monthly at 8%? At the end of the 30 year period, the net result is that you own the home, and the invested assets have grown to approximately $2,676,000. If we compare this result to the mortgage illustration with the lump sum investment returning 8% (ending with over $4,374,000 at the end of 30 years), it's clear that when the annual rate of return on invested assets is higher than the mortgage interest rate, using a mortgage and investing the cash up front gets you more dollars. With today's low mortgage interest rates, there is a strong likelihood that your rate of return on invested assets could outpace your mortgage interest rate.
You Are Not A Robot
Note, however, that this is a broad illustration that ignores several things. One is the fact that we can't predict what rate of return an investment will actually produce and when (see our analysis of lump-sum vs. dollar cost averaging for thoughts on investing a large sum of cash). Perhaps even more importantly, we must remember that people are not robots. People are likely to shift gears as they navigate the twists and turns of life (i.e. making withdrawals from invested funds, changing monthly contribution amounts, reacting to volatility in financial markets, etc).3
So unless you are a robot, this decision is more nuanced than simply looking at historical rates of return. Consider your particular financial situation and appetite for risk. First, it's helpful to consider whether you can truly afford to pay cash for the home, inclusive of closing costs, moving costs, furnishings, desired renovations/repairs, plus maintain an adequate emergency fund, meet retirement and other savings goals, spending needs, etc. If paying cash for the home will prevent you from meeting other goals, you may want to think twice. If you're trying to win over a seller with an attractive cash offer, keep in mind that it's possible to pay cash and then obtain a mortgage after the purchase.
Risk is another important consideration. If you would sleep better at night knowing that you will never have to make a mortgage payment, perhaps an all-cash purchase is for you. On the other hand, if you can stomach the ups and downs of stock market for the long term (including staying invested through down markets!) taking out a mortgage and investing the cash will likely be more advantageous financially. Keep in mind that if you have the means, a happy medium may be to pay a large chunk toward the down payment (say 50%), targeting a lower monthly payment while still leaving cash to invest.
A smart approach to purchasing home, regardless of how you pay, is to look closely at your priorities and your financial picture well in advance of making an offer.
1. Note that all calculations in this analysis have been performed using monthly compounding, in order to provide apples to apples comparison of lump sum vs. monthly investments.
2. Based on an 8.37% annualized return for the S&P 500 index in the 30-year period from 1929-1958 (the worst 30-year period for the S&P 500), assuming all dividends reinvested, adjusted to 8% to account for fund fees. See www.officialdata.org. Past performance does not predict future results!
3. For simplicity, we also ignore the impact of taxes - the potential tax savings of a mortgage if taxes are itemized, and the potential tax impact of taxes on investment income.
This content is intended for informational purposes only. Please consult your financial or legal professionals for specific information regarding your individual situation.