The Most Accurate Way to Calculate How Much House You Can Afford
Posted on August 23, 2014 by Corey • 22 Comments
When you are beginning to dream about your first home, it’s easy to get carried away with yourself as you picture what home you will buy. When my wife and I started thinking about our future home, we started to confuse needs with wants. It started out with needing two bedrooms and one bath; you know, the bare essentials. Then, we started talking about where to have our office if we would have a guest bedroom. Before you know it, we’re adding on a third bedroom, a second bath, fenced in back yard (of course for our cute dog), and so on. It would be accurate to say that the conversation drifted from talking about our first home to our dream home.
If you are buying your first home, you have to be careful about buying too big of a house. Buying too much house is not only common these days, but also disastrous for your finances. Financial experts know and understand this reality – and in an effort to help, they’ve come up with simple calculations to determine how much house you can afford. Let’s take a look at these calculations, before I offer my own solution.
Popular Calculations to Determine How Much House You Can Afford
Everyone has their own advice on what you should be able to afford. Here’s some of the popular ones:
28-40% of Monthly Income
One rule of thumb is that you can afford 28-40% of your monthly income for your housing costs. In fact, many lenders use this as a limit for establishing how much they will lend you. This means that if you are earning $10,000 you can afford to pay somewhere between $2,800 and $4,000 each month on your house and related expenses.
1.5-3x Your Annual Salary
Another popular number that is thrown around is 1.5x-3x your annual salary. If you are earning $100,000 each year, that means you can afford $150,00-$350,000 in a house.
These are just some of generalizations that help you determine how much home you can afford and they should be treated as such. While they may be helpful, they fail to take into consideration the true costs of owning a home and your current budget. You cannot rely on these estimates if you are looking to buy a home. Doing so may lead you to foreclosure or something even worse.
Expenses with Buying a Home
In order to better assess whether you will be able to afford a house, or how much of a house you can afford, you first need to understand the number of expenses that buying a home entails. It’s not the same as renting. You don’t just have a monthly payment anymore like you would if you were renting.
- Down Payment - One of the first costs that you will incur when buying a home is the down payment. Usually lenders will require 20% of the home value as a down payment, especially if you want to avoid mortgage insurance. While it is possible to buy a home with less down, usually this comes with additional costs.
- Closing Costs - These are often the fees that are overlooked when buying a home, so first time home buyer is usually forced to empty any and all emergency funds at the last minute. These fees will include (but are not limited to): escrow fees, legal fees, inspections, prepaid loan interest, and more.
- Homeowners Insurance - Homeowners insurance is usually an additional few hundred (or maybe thousand) dollars each year, depending on the value of the home and location. Usually this is a requirement to get
the final approval for the mortgage from the lender.
- Taxes - One of the additional costs that homeowners occur is property taxes. These will vary depending on the property value and the location of the property, you must account for these additional costs.
- Maintenance - Maintenance may be difficult to predict, but some say that you should budget for 1%-3% of the property value for maintenance. Some years will be less and some more. Regardless of the amount, you can bet on one thing: repairs are necessary.
- Monthly Mortgage Payment - Last but certainly not least, is your monthly mortgage payment. This will depend on the amount of the loan, the interest rate, and the duration. While you may initially aim to match the amount you are paying in rent, considering all of your other costs, you should probably look to have a lower mortgage payment than your rent.
Other Factors that Affect Your First Home Budget
Estimate how much house you can afford isn’t simply adding up all the costs and seeing if you have that much in your monthly cash flow. There are many other important things to consider.
- Retirement Planning - Do you have big retirement goals? Are you trying to max out your Roth IRA each year or maximize your 403(b) contributions? Buying too big of a house may put these goals on hold for years, if not decades. Make sure to consider your retirement planning and don’t assume that buying a home is ultimately the best thing for your retirement goals.
- Other Debts - People who have lots of consumer debt should not be thinking about buying a home. Before you even think about buying a home, figure out how much debt you have and what you can do to lower your debt. Not only will this lower the risk involved in buying a home, but this will increase your monthly cash flow thereby allowing you to pay for all of the expenses mentioned above.
- Children - I can’t stress the importance of this enough! If you are thinking about having children soon, you need to take that into consideration. Will it prevent one of you from working? If so, make sure that either you save up enough money to afford it or buy a significantly smaller home.
The Most Accurate Way to Calculate How Much House You Can Afford
While it may not be the most succinct answer to the question of how much house you can afford, below is the most accurate way to determine if you can afford a home. It’s not an exact science, and that is why you won’t see any numbers, ratios, etc. Follow these steps, be honest with yourself, and use common sense:
- Look at your take-home pay (after taxes, after tax-deferred retirement contributions)
- Add up all of your other debt (consumer/credit card, student loans, auto, etc.) and look at your monthly payments (Note: if you have high interest loans, stop here, use any extra cash to pay down these loans before looking to buy a home)
- Consider other priorities (Children: are you planning on having kids, will this affect your take home pay; Retirement: can you save more?)
- Figure out how much money you have for a down payment (you can always save more and wait before buying)
- Then, use a mortgage calculator (with adding in estimates for all of the costs mentioned above) to determine the amount you can afford
- Did I mention leave some cushion room in your monthly budget between income and all of your total monthly expenses
Readers, how did you figure out how much house you can afford?Source: www.20sfinances.com