Developing A Budget
Knowing your spending limits and developing a home building budget will go a long way towards keeping you out of financial trouble on your project, especially during the preparation of your plans and specifications. Your final working budget will be developed when you complete the cost estimating process.
Here’s an all-too-typical scenario.
A family decides to build a new home. They spend months (or years) collecting photos and magazine clippings of features and products they want to include. Armed with these and sketches of ideas they have about room layout, front elevations, and so forth, they hire an architect to design their dream home.
The plans are finished and they take them to a builder or supplier to get a cost estimate, and guess what? The home costs out at three times what they can afford. So now they must go through the gut-wrenching process of cutting room sizes and other features to get the costs down.
Before they really start, they are already dealing with a watered-down version of what they thought they wanted.
Here’s a better way.
1. Determine how much you can (want to?) spend.
2. Establish square foot costs in your area.
3. Complete a preliminary Budget Sheet (we have provided one). Click here.
4. Adjust square footage, extras, and upgrades to meet your spending limit.
Determine Your Cost Limit
On the other hand, you may be able to afford much more home than you really want or need. Everyone’s situation, of course, is unique. Most people already have some suspicion about how much they want or can afford to spend.
If you want as much as you can afford, but don’t know what that figure is, start from the end and work backwards.
In other words, determine what cash you can or are willing to put into your home and how much you can afford in monthly payments to cover whatever money you need to borrow.
Figuring out how much home you can afford isn’t all that difficult. Lenders and real estate agents do it every day. A “lender” may be a bank, a savings and loan, an insurance company, a credit union, a relative, or some other source.
Lenders use qualifying formulas to determine how much you can afford to pay each month. The formulas will vary from bank to bank but generally they compare your income to your debt payments.
If you take your monthly payments (house payment, car loan, charge cards, etc. – not utilities, food, entertainment) and divide it by the sum of all your monthly income, the number you come up with should not exceed .33 to .36, depending on the percentage of the cost of the home you are planning to borrow (80%, 90%, 95%?).
Another typical guideline is that the total monthly house payment should not exceed 25% of your stable monthly income.
The monthly house payment used in these qualifying formulas consists of four items: principal, interest, taxes and insurance (PITI). A portion of the monthly house payment will go towards reducing the principal (the amount of money originally borrowed).
A portion will also pay the previous month’s interest on what you still owe. Below is a brief discussion of the other two items.
In addition to principal and interest, you will also have to pay property taxes. These are levied by the city, the county, and in some cases the local school board. The tax bill is due each year. It can amount to a hefty sum, depending on where you live.
If you do not pay your property taxes, the government can seize and sell your land to get its money. The people who loaned you the money to buy the home are also looking to the home itself as the ultimate security to guarantee repayment.
If you didn’t pay your taxes, and the government foreclosed (seize and sell), how could the bank get their money back? To protect their interests, most lenders will estimate the annual tax bill and make you pay 1/12 of that amount each month along with your principal and interest.
They accumulate this money in a special account called an “escrow” account. At the end of the year, the lender pays the property tax due on your home out of the funds that are in this escrow account. This assures the lender that the taxes are paid.
Lending institutions also worry about the possibility of anything happening to the home that would damage or destroy its value and thereby jeopardize the collateral securing their investment. Such things may include a fire, a falling tree, or a tornado.
Most lenders will require you to carry a home insurance policy to guarantee that funds will be available to repair accidental damage to the home. Many lenders will also require payment of the premium for this insurance to be made in a fashion similar to the tax escrow described in the previous paragraph.
These four items – principal, interest, taxes, and insurance, are the items considered in most formulas that are used to determine how much house you can afford. In addition to PITI, some formulas also use maintenance of the home – repair of worn or broken items, repainting, etc., and income taxes.
By knowing your income, your monthly debt obligations, and how much cash you are going to put up, a lender or real estate agent can use their knowledge of current insurance rates, propert taxes, and standard amortization (payment) tables to help you work backwards to find out how much home you can afford (total price).
And they can usually do it in a matter of minutes. A good online resource for determining how much you can afford is www.nolo.com. In their search feature, type, “qualifying for a home loan.”
BALL PARK FIGURES
The following table may give you some “ball park” feel about the relationship between interest rates, mortgage amounts, monthly payments, and annual income needed. A 30-year loan is assumed in each case. The monthly taxes and insurance are estimated at 12% of the monthly principal and interest payment.