Are you ready to buy a home? How much can you afford? Should you buy as much as you can afford?
To afford a home purchase, you first need to have enough liquid assets for the down payment and closing costs. The amount you need for a down payment depends on the amount of your mortgage loan. You should supply a down payment equal to at least 20% of the lesser of the purchase price or the home value in order to avoid paying private mortgage insurance. The closing costs charged by your mortgage lender can be an additional few thousand dollars but will greatly depend on your specific mortgage terms. You may also be required to fund an escrow account at closing, which the lender will use to pay your property taxes and homeowners insurance when due. You can contact mortgage lenders to collect total closing costs estimates based on your prospective home purchase.
In determining how much cash you need for the down payment and closing costs, you should remember to maintain sufficient liquid assets for an emergency fund. The amount you need for an emergency fund depends on your specific cash flow situation, but most people should maintain liquid assets equal to at least three to nine months of expenses. You should not utilize your emergency fund for the home purchase down payment because you may need those funds for unexpected expenses after moving into your new home. You should have enough total liquid assets to cover the down payment, closing costs, and your emergency fund.
To afford a home purchase, you also need enough cash flow to pay the ongoing costs of home ownership. Estimate how much will be your total costs for the mortgage payment, homeowners insurance, property taxes, homeowners association fees, maintenance services, and all home utilities. You can receive most of these cost estimates from your mortgage lender and real estate agent. Compare those expected home ownership costs to your current living expenses. If you are currently spending as much or more for your residence, then you should be able to transition to the new home without sacrifices in your budget. If your net cash flow will decrease as a result of moving to the new home, you need to determine where you would sacrifice in other areas of your budget. You must maintain a positive cash flow while owning the home in order to replenish your emergency fund when needed.
Mortgage lenders will estimate what price house you can afford by assuming certain percentages of your income will be allocated to housing expenses and other debt repayments, but you should view the amount they tell you as a price limit rather than a price target. How much income you actually want to dedicate to housing expenses will depend on your other financial plans. For example, you may want to spend less than you can currently afford if you plan to increase spending on other goals like growing your family. On the other hand, you may want to spend all that you can currently afford if you expect your income will increase much faster than inflation and you are willing to delay increased spending on other goals.
The main benefit of spending less than you can currently afford is that you allow some flexibility in your budget for any expected or unexpected changes in your cash flow. The biggest risk in buying a home for less than you can afford is that you could potentially outgrow a lower priced home sooner than you would a higher priced home. You should avoid cycling through your home too quickly in order to provide the home adequate time to appreciate enough to cover all your fixed costs of buying and selling the home. Assuming you will be satisfied living in your home for the next several years, spending less than you can afford would be a financially wise decision. You will better enjoy your home if you can comfortably afford your home.