What to Consider When Setting Your Budget
Buying a home is a significant milestone in a person’s life. And while it’s definitely an exciting time, there are some serious issues to consider — one of the biggest being money. To set yourself up for a successful homeownership experience, it’s important to first establish a realistic budget. Here are just a few tips to get you started.
Understand the potential risks
While owning a home is considered by many to be the American Dream, it can quickly turn into a nightmare if you get in over your head. Homebuyers who don’t set a solid budget and/or buy more than they can afford run the risk of becoming “house poor.”
In general, financial experts say if you spend more than 30% of your total household income on housing, you could fall into that “house poor” category.
The Joint Center for Housing Studies of Harvard University said that “even before the pandemic-induced downturn, some 37.1 million households (30.2%) spent more than 30% of their incomes on housing.” Of that group, 17.6 million households had severe burdens, “paying more than half of their incomes for housing.”
“Nothing ruins the excitement of buying a home more than realizing 2 to 3 months in that you bit off more than you can chew,” said Bill McLeod, mortgage manager with CASE Credit Union. “That’s why I strongly advise our members not to get caught up in what they’re approved for, but instead to focus on what they can truly afford.”
Consider more than your DTI
When determining your mortgage pre-approval amount, one of the factors a lender considers is your debt-to-income (DTI) ratio. Your DTI is calculated by dividing your total recurring monthly debt by your gross monthly income. Typically, lenders like to see a DTI smaller than 36%, with no more than 28% of that going towards servicing your mortgage.
For example, if your gross income is $5,000 per month, the maximum amount for your monthly mortgage-related payments at 28% would be $1,400 ($5,000 x 0.28), and your maximum debt load should not exceed $1,800 ($5,000 x .36).
Keep in mind these are general guidelines. Numbers can vary depending on your lender and loan program. In most cases, 43% is the highest DTI a borrower can have and still qualify for a mortgage. But there are other factors — like credit score and down payment amount — that also come into play.
The most important thing to remember is that when lenders look at your DTI, they are factoring in debt like monthly car payments, credit card payments, child support, loan payments, etc. A mortgage pre-approval doesn’t consider personal financial goals, new homeownership costs, and lifestyle expenses.
“Cell phones, dining out, weekend travel, gym memberships, childcare costs…these are expenses your lender isn’t aware of,” said McLeod. “Your DTI can provide an estimate of your monthly affordability, but it’s up to you to fill in the gaps based on your spending habits to determine your comfort zone.”
Get started on the budget
So, how do you put together a realistic budget? The Consumer Financial Protection Bureau (CFPB) suggests the following steps:
Take a look at your current spending patterns. Review your checking account and credit card history for the last several months, save your receipts, or carry a small notebook to record expenses. You can also sign up for an online personal financial management tool to help track spending.
Draw up an as-is monthly budget that accurately reflects your current spending. Include a "miscellaneous" category for things like car maintenance, travel, eating out, etc. If you make regular deposits to an emergency fund or other savings goal, include these as well. Look back over several months to make sure you don’t miss less frequent expenses like insurance payments, medical expenses, school clothes, tuition, support for family members, seasonal and recreational costs, gifts, charity, and vacations.
Add up all the categories and compare this budget to your monthly take-home pay. How much is left over? If the amount you typically have left in your account doesn’t match the amount in your budget, take another look at the numbers and adjust accordingly.
Now you can decide how much you can afford to spend on a monthly home payment. Remember, your total monthly payment includes mortgage principal, interest, property taxes, homeowner's insurance, and any mortgage insurance. You also need to estimate expenses for utilities, home maintenance and improvements, and HOA fees, if applicable.
After reviewing everything, you may be perfectly happy to take on a higher monthly payment in exchange for cutting out some restaurant trips or taking fewer weekend getaways. Or you may crunch the numbers and decide you aren’t willing to give up your current lifestyle and staying on the lower end of your budget may be best.
“It’s not uncommon for a borrower to be approved for more than they expected, so it’s important to review your finances and establish a budget before meeting with a lender,” said McLeod. “On the other hand, if you aren’t approved for as much as you hoped, an experienced lender should be able to look at your financial profile and point out areas you can work on to get in a better position in the future.”
If you would like more information, set up a consultation with a professional, local lender. You can find a list of providers by visiting the Greater Lansing Association of REALTORS® website at www.lansing-realestate.com.