how to make a budget

How to Make a Realistic Budget for Buying a House

Before you start looking for your first home, you should sit down with your family members and discuss the most important thing – the budget for buying a house.   

Yes! You need to know how much you can afford to pay for a new house first!

Bring out your trusty pen and house hunting notebook, create a new spreadsheet, use an app or any method you are comfortable with and start the budgeting process. 

To help you get started, here’s a simple six-step guide.

Step #1. Compute your household income

How much can you spend on a new house?

If you’re not sure, it’s time to flex your brain muscles.

Get started by listing all your income sources.

If you are single and your work two jobs where you receive a monthly income of $2K for Job A and $3.5K for Job B, your total monthly income is $5.5K ($2K plus $3.5K). You should also include the income of your spouse in computing the gross monthly income if you are married.

Step #2. Make a list of all your household expenses

This time make a list of your monthly expenses. Include your rent, utilities, food, transportation, savings, clothing, transportation and personal, medical, and recreation expenses in the list.

Don’t forget expenses related to loans such as auto loans, credit card debt, and student loans you are paying for.

Then, add all your monthly expenses.

Step #3. Calculate your available cash

After going through the long process of listing all your expenses, it’s time to check your bank balances. You can’t just look at your gross income when you’re planning to buy a home. Assess your cash availability too because you have to pay the down payment and closing costs.

You may have heard that you have to pay the 20% down payment when buying a home but that’s not necessarily true. It’s possible to buy a house with a lower down payment like most Americans. Some even put down as low as 3% as a down payment.  

After checking all your bank balances, get the total of your available cash. Deduct your emergency fund and other funds which have already been allocated for a specific purpose. What’s left should be your free cash which could be used to pay for the down payment and closing costs. Your closing cost can be from 3 to 6% of the property’s price.

If you don’t have much cash that you can put down as down payment, add “shopping for first time home buyer or home buyer grants” on your to-do list. There are several programs for home buyers administered by the local housing department which may help you pay for the down payment and closing costs. 

You may be eligible for these grants especially if it’s your first time to buy a home and you come from a low-income household. However, don’t include these grants on your budget for buying a house! It’s always better to be more conservative when you are working on your budget. 

Step #4. Calculate the cost of owning your first home

The cost of owning your new home including any payments for insurance and property taxes should not exceed 25% of your gross income. Gross income refers to the income you see in your paycheck before any deduction.

This means that in the example above, the maximum amount you can spend on your mortgage payments is only $1,375 (25% of $5.5K).

Pro Tip: Trulia has a useful tool to help you calculate how much you can afford based on your income.

Mortgage Ratios

The 25% criteria is actually a conservative approach to budgeting. Most mortgage lenders will compute how much you can afford to pay for your mortgage based on your gross income. There are generally three types of ratios that they may look into.

The Golden Ratio

Most lenders will compute the maximum monthly mortgage payments you can afford based on 28% of your gross income.

If you have a combined income of $5.5K, your mortgage payments should not be more than $1,540 (28% of $5.5K). This ratio refers only to your mortgage payments

Housing Payment Ratio

Aside from your mortgage payment, you should also consider repair and maintenance fees, homeownership association fees, as well as repairs and maintenance.

After factoring in additional fees such as association fees, insurance, and property taxes, your total monthly payments for your new home should not be more than 32% of your gross income. If your gross income is $5.5K, your monthly payment should not be more than $1,769 (32% of $5.5K) per month.  

Debt Ratio

Let’s take those ratios one step further and look at all your other debt-related expenses. Do you have auto loans, student loans or credit card debt?

Check the list you made in Step #2 and add all your debt-related expenses. This time include your housing cost in the total. The sum of all those loans should not exceed 36% of your gross income. If you earn $5.5K per month, all those loan payments should not be more than $1,980 (36% of $5.5K).

You may also divide your total expenses by your gross income to get the percentage. For instance, your total debt including your housing payment is $2.5K and you are earning $5.5K per month, your total debt makes up 45% ($2.5K divided by $5.5K) of your income. You can do the same for other ratios.

If you don’t meet the debt ratio, most mortgage companies will reduce your loanable amount or the maximum amount you can borrow. If it’s clear that you can’t afford more debt based on your current situation, the financing company may reject your application.  

Take note that 36% is the rule of thumb but lenders process applications on a case by case basis. Some financing facilities may impose a maximum debt ratio of 40% or more.

Is your budget for buying a house too high or too low for your first home?

Now that you have your figures down, here’s some interesting facts which may help you have a better picture of how the rest of the country is doing.

There’s a standard to determine if your home is affordable or not. If you are paying more than 30% for your housing, you are most likely overspending.

The average American spends 37% of their take-home pay on housing. Some people, especially those in New York and in the Northeast spend even more than that!

The average household spent $20K on housing from July 2017 to June 2018. This boils down to about $1.7K per month. Take note that your average housing cost varies depending on where you live.

Step #5. Think about possible additional expenses 

Depending on the location of your new home, you may have to increase your transportation and utility budget.

Will your new home address be cooler or hotter than your old residence? Is it closer or further from your workplace? These costs may seem insignificant, but they can add up and you have to include these in your budget for buying a house.

Don’t just think about your mortgage, consider other costs you have to shoulder as the homeowner. These expenses could include:

Home maintenance

Every year, you should set aside 1% based on your home value for repairs. This ratio could actually range from 1 to 4% but you can take the conservative approach for the first few years. This means that if your home’s value is $100K, you should budget at least $1K for maintenance for each year.

Home insurance

The national average for home insurance in 2018 is $1,288 for a $200K home with a $100K liability and $1K deductible. Based on estimates, Florida has the most expensive home insurance at $3.5K – almost 200% of the national average. New York home insurance is cheaper at $935, New Jersey averages are at $711 and Hawaii residents pay the lowest insurance at $337. Depending on your home’s location, you may also have to pay for a separate earthquake or flood zone insurance.

Heating and cooling costs

Almost 85% of homes in the US have an air conditioning system which could cost you around $375 in electricity bills every year. Heating systems cost even more at around $679 annually. Heating costs may range from $1K to $2K depending on your heating system. If any of your HVAC systems break down, you may have to spend $300 to $500 for repairs.

Roof replacement

How old is your roof? The lifespan of a roof ranges from 15 to 50 years with asphalt shingles on one end and clay tiles on the other. Laminate shingles last from 24 to 30 years. Wood and metal shingles can last for about 30 to 40 years. 

Homeowners association fees

Also known as HOA, this expense may cost from $200 to $4K depending on where you live. If your building has several amenities, you would most likely pay higher HOA fees.

Foundation repair

On average, you have to pay around $4.5K for foundation repair issues. Cracks may cost you around $620 for each 10-foot crack, leaks around $2.5K to $5K, and bowed basement walls are the most expensive at $5K to $15K based on Home Guide estimates.

Property Taxes

Now that you own your home, you will be liable to pay for the annual tax to your local government. You will most likely receive a tax bill based on the assessed value of your home. You will have a better idea of how much this tax will cost while purchasing your new home. Yes, you can take a tax deduction for the property taxes you paid but only up to $10K.

Other costs to include in your budget for buying a house

Aside from these things, you would most likely spend for pest control, lawn care services, housekeeping, appliance repairs, and household furnishings. You may not have to pay all of these things all in one year but it’s better to set aside a part of your budget for buying a house for these things.

If you find a house you love that will require extensive repairs, consider those costs as part of your home’s value. If you only consider the cost of your home in your budget, you may overspend.

Another factor to consider is your personal situation. Things will not remain the same in the coming years. While you can’t tell what could happen to the future, you can predict events which are likely to happen in the coming years.

For instance, if you get married, decide to have a baby or support a family member, you may have more expenses. Include all these possible expenses in your list and allocate a budget for those items. This will help you see what the situation may be like in a few years.

Step #6. Make adjustments on your budget for buying a house

After brainstorming about all of your possible expenses, it’s time to go back to your list of expenses and include all those things. Compute the ratios again and see if your home is still affordable based on the numbers you came up with.

While at it, you may want to reduce some of your expenses to make room for others. Think about the best way to allocate your income. If you can’t finish your budget in one sitting, don’t worry. Making a budget for buying a house can be a tiring process but you have to set a deadline.

If there are some changes in your income such as a promotion or a transfer which may affect your budget, you should also review the figures and make the necessary changes.

Beware of the Payment Shock

If there’s a large gap between your mortgage payment and your monthly rent, you may have “payment shock.” While it’s possible to make a budget for your mortgage payment, you can practice ahead of time so you will have more room to adjust.

At least six months before you start making mortgage payments, pay the rent as usual. Then, compute the difference between your current rent and your mortgage payment. Transfer that amount to a separate savings account. It would be better if you could include any applicable taxes and insurance payments.

During the six-month period, you can make adjustments to your lifestyle and budget to meet your mortgage payments. The savings you accumulated may also serve as a buffer.

How to Budget for Buying a House

If you have plans to buy a home, you should always start with a budget and follow these six steps:

1. Calculate your gross income.
2. List and add up all your monthly expenses.
3. Compute how much available cash you have.
4. Find out how much you can afford to pay for your mortgage every month.
5. Forecast additional expenses.
6. Make changes on your budget based on your forecasted expenses.

You should also take the time to review your budget when necessary. 

Once you’re one with the budge for buying a house, you are one step closer to owning your first home. 

Related Articles:

Pre-Qualification for a Mortgage: Do You Need It?
Mortgage Lenders and Mortgage Brokers: How They Help You Finance Your Home
10 Tips on How to Interview a Realtor when Buying a Home
Buying A House Checklist: What Should I Be Looking For In A House?
How to Use the Home Loan Calculator Like an Expert

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