For most people, the biggest financial transaction of their lives is buying a house — and it gets even bigger when you already own a home and are trying to buy a new one. Generally, there are three ways to manage this tricky situation.
Sell first, then buy
This scenario is the most common because it’s the most financially feasible. You start this process by selling your home, then getting pre-approved for your new home so you know how much you can afford. Your lender’s affordability analysis will first look at your available cash for down payment, then determine your monthly obligations.
Suppose your down payment will come from the sale proceeds of your home, which perhaps you bought 10 years ago for $200,000 using 10 percent down, and are now selling for $250,000. Thanks to IRS tax benefits for owner-occupied homes, you’re exempt from paying capital gains taxes on gains up to $250,000 for a single person, and up to $500,000 for a married couple. But you will pay about 6 to 7 percent of the sale price for all the fees associated with selling a home, including real estate agent and marketing fees, transfer tax, and title fees. Calculating conservatively, estimated net proceeds from your sale will be about $85,000.
Using this $85,000 as your down payment on a new home purchase of $350,000 with a 30-year fixed loan, your total monthly obligations on the new home are $1,644 — comprised of a $1,227 mortgage payment using today’s 30-year fixed rate of 3.75 percent (mortgage rates change throughout each day), property taxes of $350, and homeowners insurance of $67.
To afford this $350,000 price with $85,000 down, you’d need to make $63,000 per year and have no more than $300 per month in non-housing debt obligations.
To prep before you talk to a lender, you can calculate your own monthly payments using any down payment and purchase price you want, and you can also calculate how much new home you can afford.
Buy without selling first
This scenario has become common in recent years as tight inventory in many markets has made it harder for people to find a new home while they sell their existing home.
To buy without selling first, you need enough cash for a down payment on a new home, and you’ll need to assess with your lender whether you can afford two sets of housing payments.
Using the example above of living in a home you bought 10 years ago for $200,000 with 10 percent down, you might have a total monthly obligation of about $1,215 — comprised of a $859 mortgage payment, assuming you refinanced along the way into a 4-percent rate, property taxes of $200, insurance of $67, and mortgage insurance of $89.
If your target down payment was 10 percent on the new $350,000 purchase, your total monthly obligation would be $2,030 — comprised of a $1,459 mortgage payment with a rate of 3.75 percent, property taxes of $350, insurance of $67, and mortgage insurance of $155.
Both properties combined are $3,245 per month. If you add an estimated $300 extra for non-housing debt, you’d need to make about $99,000 to qualify for the new home.
But what if your income falls short? Knowing you’ll net about $85,000 on your sale, you can try to get a gift for this down payment and pay it back when you sell your existing home. Doing so means you’d only need $88,000 in income to qualify for the new home before selling your existing home.
Buy and convert existing home to a rental
This approach is for people who want to keep their current property as a long-term investment. Depending on the lender and your profile, you might be able to count rental income on the current property to qualify for the new loan.
If you can’t count rental income, your lender would qualify you as noted above with the full obligations of both properties plus non-housing debt, meaning you’d need to make $99,000 to qualify (using the sample home prices and down payments).
If you can count rents, most lenders allow you to use 75 percent of rental income to offset expenses when qualifying for the new home. If we used this formula in a market like Denver — where median rents are $1,650 — you’d need to make $65,000 to qualify to carry both homes if you were being given credit for rents. Check rents in your city to see if this approach would work for you.