Chances are, you’ve been dreaming about and saving for your first home for quite some time. It makes sense, after all, for many American’s buying a home is the single largest purchase they’ll make in their lifetime. And while it’s one thing to know what you want in a house, it’s another thing to know what you can afford.
Setting a home buying budget is more complicated than using the amount a lender pre-approves you for. In fact, home shopping based on that number alone without taking into account other monthly expenses can lead to financial hardship down the road.
To develop a realistic homebuying budget you need to understand how lenders determine your pre-approval amount as well as all the other costs associated with buying and owning a home.
How Lenders Determine Your Pre-Approval Amount
To get pre-approved for a mortgage, lenders will make an informal review of your finances including your annual income, your debt-to-income ratio, and your credit among other things.
Mortgage lenders often defer to the 28/36 rule when determining your lending amount. Investopedia reports, “According to this rule, a household should spend a maximum of 28% of its gross monthly income on total housing expenses and no more than 36% on total debt service, including housing and other debt such as car loans and credit cards. Lenders often use this rule to assess whether to extend credit to borrowers.”
The 28/36 rule relates to what lenders call your debt-to-income ratio (DTI).
- Front-end DTI: This measures your total housing costs in relation to your income. The preferred percentage for front-end DTI is 28%.
- Back-end DTI: This measures your total housing costs plus all your other monthly debts like credit card payments or student loans in relation to your income. The preferred back-end DTI is 36%.
Maxing out your budget to meet the amount you’re pre-approved for, isn’t always a great idea. There are a variety of other expenses to consider.
Additional Home Buying Expenses
Some additional costs associated with the home buying process for first-time homebuyers to consider are:
- Down Payment: First-time homebuyers probably hear plenty of talk about a down payment that’s 20% of your purchase price. If you can make a down payment of 20% you’ll avoid paying private mortgage insurance (PMI). The monthly cost of PMI is an additional 0.5% - 1% of the loan amount. The higher your down payment, the less you’ll pay for PMI.
When you’re setting your budget, you may find that making a 20% down payment on a less expensive home makes more financial sense than making a 10% down payment on a more expensive home.
- Closing Costs: Closing costs can run a homebuyer 2% - 5% of the home’s purchase price. In Illinois where the median home value is $181,000, you can expect your closing costs to be between $3,600 - $5,400. That’s a big chunk of change. Your REALTOR® can let you know if your closing cost can be negotiated.
“In a buyer’s market, it’s often possible to negotiate that the seller pays a portion of your closing costs,” said Joe Zimmerman, owner of the Zimmerman Group. “However, a seller can’t help pay for any fees related to your mortgage such as a title search fee or real estate transfer taxes because these fees are typically rolled into your mortgage’s total cost.”
Your down payment and your closing costs are important to consider as you set your home buying budget at the beginning of your home buying journey.
Additional Home Ownership Expenses
When you’re looking at your total housing costs in relation to your income (DTI) there are certain expenses that lenders don’t always consider.
- Utilities: The cost of your monthly utilities (electricity, natural gas, water, waste disposal, internet, and cable) can vary widely depending on where you live. However, on average homeowners should budget for around $400 a month to cover these costs.
- Repairs: It’s impossible to predict everything that might go wrong when you buy a new home. But, having a home inspection before you buy will help you determine if you can expect any big fixes soon. You can use this information to understand if a home is truly within your budget.
- Maintenance costs: Generally, you should budget 1% - 4% of your home’s value for yearly maintenance. That means for a $300,000 home, you should save between $3,000 and $12,000 for annual maintenance. This is an important consideration to avoid overextending yourself when you’re setting your home buying budget.
- Property taxes: Illinois has the second-highest property taxes in the nation. According to SmartAsset, “The typical homeowner in Illinois pays $4,527 annually in property taxes. In some areas, this figure can be upwards of $6,000.”
Property taxes can either be paid directly to your local tax office in a lump sum or divided and paid as a part of your monthly mortgage payment. Whichever way you chose to handle the cost, it must be considered in the initial stages of the home buying process.
For first-time homebuyers, smart planning and thoughtful budgeting are essential pieces of the home buying process. Working with an experienced REALTOR® to make sure you’re paying a fair price on the home of your dreams and considering the entire financial picture will ensure this huge financial investment is a long-term success.
With a clear picture of your home buying budget, you’re ready to pick a mortgage lender. However, not all lenders and loans are created equal. Find out How to Pick a Mortgage Lender and learn about Resources for First-Time Homebuyers in Illinois in our other blogs.
The Zimmerman Group works hand in hand with trusted and knowledgeable lenders to help you experience something greater during the homebuying process.