Budgeting & Planning
Let's regroup: you have now decided that renting to home ownership is a pursuable option for you and your family. Now, before you begin contacting sellers and looking at properties you must decide on the type of budget you have to go into the market with. Remember, the end goal of renting to own is to buy that home. You as the buyer must believe you will have the ability to do so at the end of the rental period or risk losing the credit you've built up. Learning how to budget will require examining what you can afford, as well as understanding the Debt- to-Income Ratio used by mortgage lending companies.
Before you look at your first possible home it's important to have an idea of what you can afford. To determine this you will need to take a look at your budget, your income and have an understanding of the expenses that go into owning a home.
Most mortgage companies agree that you should not purchase a property that will exceed 29% of your household income. The 29% is not just your payment, but all expenses related to home ownership. This includes things like homeowners insurance, private mortgage insurance, property taxes, possible homeowner association fees as well as the actual payment.
To break it down into a more practical example, if you have an average income of $50,000 than the cost of purchasing your home should not exceed around $1208 a month (Annual income divided by 12 to get monthly gross income multiplied by .29 for a standard DTI). You will need to get an estimate on homeowners insurance in your area, have an idea what property taxes run, and find out if you will require a PMI payment (budget for it just in case). Considering the whole picture is vital, you will be on the hook for more than your rent or housing payment.
One important note is to consider the area you plan on living in as well as your own debt, personal bills and expenses before estimating what you can afford.
Once you have an idea about what you can afford, it is important to compare that with what potential lenders may feel you can afford
. Mortgage companies use a quick formula to determine what payment a buyer can afford in their monthly budget. This formula is called the Debt-to-Income ratio or DTI.
The DTI uses two affordability ratios, the Front Ratio and the Back Ratio. These ratios are used by mortgage companies to determine the maximum amount a potential buyer may qualify for.
The front ratio is the percentage of income that lenders believe a buyer can potentially afford to pay for housing costs. Remember this includes more than just the rent or mortgage payment. Mortgage companies tend to follow the rule of thumb we already addressed which is 29% of total income.
The back ratio includes other obligations in addition to those calculated in the front ratio. These include things like credit card payments, student loans, child support, car loans and other miscellaneous debts. The ratio for these payments is 36%. This means that potential lenders want to see potential buyers paying no more than 36% of their income out to debts.
These ratios do not include other expenses like utilities, groceries or child care.
Calculating Your Estimated Purchase Price
Once you've arrived at comfortable rate you can afford, how do you calculate that into the purchase price of a home? Let's do some example calculations. We know that the monthly cost of paying for our home should not exceed $1208 (based on an income of $50,000). Here are some possible numbers:
- Estimated Property taxes at $2500
- Down Payment of $5000
- Home Owners Insurance Annually at $450
- Monthly PMI at $70
These add up to a cost of $315.50 a month, leaving just $892.50 to cover interest and rent payment. This allows us to look at homes around the $150,000 price range.
Budgeting is crucial in all areas of your household finances, but especially true when it comes to purchasing a home. Budgeting effectively means you will have a much higher likelihood of success in dealing with your rent-to-own purchase and put yourself unknowingly into a situation you aren't able to afford.