Step 3: Set Your Price Range
To determine the maximum down payment you can afford, first calculate the total dollar value of the following four items:
- Money you're saving for emergencies.
- Your closing costs, which usually run about 1-2% of your purchase price. Normally you have to write a check for this amount; however, you can have either the seller or your lender pay your closing costs.
- Cash to improve and furnish your new home.
- Assets you can't or won't liquidate, such as jewelry, life insurance, and retirement funds.
Then, subtract the total from your net worth. The result is the amount of your maximum down payment.
If any of the money you are planning on using for a down payment is tied up in assets such as real estate or jewelry, allow plenty of time to sell or borrow against them.
Remember that you will need a portion of your down payment as "earnest money." This is typically a payment of $1,000 that you give the seller's Realtor when you make your offer. Also, as much as 5% of the purchase price (minus the $1,000 in earnest money) is due approximately 10 days after the offer is accepted, to be held in escrow until the closing.
Most loans require a down payment of at least 3% to 5%, depending on the type and term of the loan, although 100% financing loans are certainly available. Making a 20% down payment frees you from mortgage insurance premiums and may qualify you for some fast-track financing programs.
Making a bigger down payment lowers your monthly mortgage payments and cuts down the interest you'll pay during the life of the loan. However, you could try another tactic: Make a smaller down payment, and then invest the funds you have available so that they earn more than the interest rate on your loan plus the mortgage insurance premium. A smaller down payment also gives you higher tax deductions for mortgage interest.
Ratios and Budgets to Help Assess Affordability
Determine what monthly payment you can afford by creating a basic budget that lists your gross monthly income minus long-term debts, plus any special liabilities you might have, like unusually high medical bills.
Start with your gross monthly household income. Many lenders set a ceiling where you can spend no more than 28% of your gross monthly income on principal, interest, taxes, and insurance (PITI). These ratios vary with lenders, however; some may allow your maximum monthly payment to be as high as 33% of your gross monthly income.
Lenders also take into account your other long-term debts such as car loans, alimony, or college loans. They allow no more than 36% of your gross monthly income to be spent on PITI and long-term debts (again, this varies by lender, with some allowing as much as 38%).
These ratios can help you work backwards as well. Let's say you have a monthly household gross income of $6,000. Using the 28% ceiling for PITI, you could afford $1,680 per month.
However, if you pay $600 a month in auto and tuition loans, you could afford only $1,560 for PITI. ($1,560 PITI up $600 long-term debt = $2,160, or 36% of monthly income).
Another rule of thumb is that the purchase price of your home should not exceed four times your annual income. In the example above, your annual income was $72,000, so you might be able to buy a $288,000 home. A $1,560 PITI on a 5% loan is what you'd estimate on a $290,000 loan—greater than you'd need for the $288,000 purchase price minus the down payment.
What Can You Really Afford?
The ratios lenders use to determine what you can afford are necessarily impersonal. Different people with similar incomes and net worth may nonetheless have different lifestyles and spending habits, so you'd be wise to verify what you actually spend each month and determine for yourself what maximum PITI you can comfortably afford. It may be more, or less, than the standard based solely on your income, long-term debt, and net worth.
What Does the Future Hold?
Take a look at the future: Will you need to pay for day care? Will your family outgrow daycare? Will there be tuition increases? A new car, or repairs on an aging one? Salary raises? No one has a crystal ball, but you don't want to either overextend yourself financially, or buy less home than you can afford. Your Chicago real estate agent will help you assess your personal situation and determine a budget range based on your present and future goals.