Calculating how much you can afford on a new home essentially involves subtracting the total cost of purchasing the home from the total funds available for the new home. If the number is negative, then either too much money is being allocated to other budget allocations, or not enough money exists for the home purchase.
I: Steps toward calculating affordability
Step 1: Tally costs
The first step in calculating how much new home you can afford is tallying costs. To do this determine all the expenses the home purchase will require including furnishings and remodeling. This will give you an idea of how much the home will really cost as the sale price is just part of the total cost, albeit the larger part in most cases. The use of a mortgage calculator may also be helpful in this step.
Step 2: Reassess
After total costs have been estimated, reassess them to see how they can be reduced and if they are practical. There’s a good chance a second review of your costs will reveal the price of convenience and wants, rather than practicality and needs. For example, not all mortgage lenders charge the same fees, and not all homes may need to be remodeled. Shopping around for homes and mortgages can take time, but can also save money.
Step 3: Budget
When a more reasonable cost basis has been estimated or found, you may need to budget those costs so they are affordable. To do this, gather financial statements, bills, and pay-stubs. If it hasn’t already been done, create a worksheet that shows what your monthly expenses are, and how much money is left over at the end of the month. Money may need to be reallocated to pay for expenses associated with the new home.
Step 4: Forecast
Property taxes, insurance costs and unforeseen home maintenance expenses are a real probability when calculating the affordability of a new home. For this reason, building in financial redundancy into a new home’s cost is a good idea. In other words, make sure there is enough extra money put aside to account for quick repairs and increases in home maintenance costs. Keep records as they may be tax deductible after and if the home is sold.
II: Costs associated with new home purchases
When calculating how much new home you can afford it is helpful to be aware of just how many extra costs there may be. Expenses may seem to come out of nowhere with a new home, and being prepared for these expenses is a good idea if you want to stay in the home. The following are some of the costs that may be included and that might be avoidable in some cases.
• Purchase method
If a new home is being purchased in cash or with seller financing, the cost structure is likely to be different than if a traditional mortgage is used through a mortgage lender. Cash purchases and seller financing don’t require the same Realtor or agent costs if any, and don’t have as many fees as with mortgage lenders.
• Origination fees
What mortgage calculators don’t really do is calculate the origination and other fees associated with the cost of the new home if a mortgage is used. These fees and expenses can add up to thousands of dollars and include title search, underwriting, application, inspections, appraisals and more.(1)
• Realtors and real estate agents
If using a Realtor or real estate agent, the buyer of the home may foot the bill which is sometimes split between the seller and buyer representatives. This can add an extra 3-6% on the purchase price of the home. Realtors and agents aren’t necessarily needed, but the cost can end up saving more costs if they negotiate well and save you from having to put more money into the home after buying it.
• Downpayment and Interest
The downpayment and interest on a home are two of the larger expenses, but far from the only expenses to calculate into the affordability of a new home. At minimum these costs may amount to an upfront cost of an additional 3-5%. For example, a 3% down-payment on a home sold at $100K with an interest rate of 5% would cost $3,000.00 plus the interest on top of the first months payment or $520.72.(3)
• Warranties
Both new and used homes can come with warranties, but those warranties may cost extra and may not always be the best idea. The U.S. Federal Trade Commission (FTC) claims a an arbitrated warranty dispute can cost thousands of dollars.(2) To properly account for this risk, consider the quality of the warranty and the claims history of the warranty provider.
Sources:
1) http://bit.ly/97ivU2 (Federal Reserve)
2) http://bit.ly/aPpL9J (Federal Trade Commission)
3) http://bit.ly/spG6m (Mortgage Calculator)