How Much House Can I Afford?
Many first time home owners struggle to find the answer to what would seem to be the simplest part of buying a home; How much can we afford? The answer to this question can become complicated, because people have wildly varying financial circumstances. Because of the complex nature of individual obligations, many financial experts recommend various “rules of thumb” to help work out an answer. The problem of course, is that there are many “rules of thumb”, depending on who you talk to.
Let’s review a few of the common methods recommended to help determine the amount of house you can afford.
3 Times your gross annual income.
Some experts recommend simply multiplying your annual income before expenses to determine what you can afford. So if you earn $50,000 a year, and your spouse earns $50,000, your combined income would total $100,000. You should be afford a $300,000 home, with a $1400 payment at 3.92% interest for 30 years.
The obvious flaw in this method is that it does not consider your debt. For example, what about real estate taxes and homeowners insurance? What are the utilities going to cost? AAA’s 2015 monthly vehicle expense average for the US put the cost of owning a mid-level sedan and an SUV at about $18,000 a year, or about $1500 a month. Do you have student debt? Medical bills or high insurance premiums? What about credit cards? There are a lot of moving parts to consider that are unique to individuals.
Keeping Housing Related Expenses Less Than 28% of Your Monthly Gross Household Income
Another suggested method is to aim to keep all housing related expenses (mortgage payment, real estate taxes, and homeowner insurances) to less than 28% of your monthly household income. Using the previous example, if your monthly income is $100,000 divided by 12, you average $8333.33 per month. Therefore, your monthly housing expenses should be kept below $2,333.33 ($8333.33 x 28%).
This rule is considered standard for many lenders.
Total Debt Less Than 36% of Monthly Gross Household Income
This “rule of thumb” works to take into account all of your monthly debt obligations. From the example above, 36% of $8333.33 would be $2,999.98.
This method is probably more helpful to understanding your real financial situation, because it works by beginning with your debt. If you are making a $800 in car loan payments a month, $150 in insurance, $250 student loan payments, $500 payments toward credit card debt, and $150 in cell phones, you only have $1,149.88 left for your house payment. Clearly you would have to reconsider the house you wanted.
But why can’t you stretch your budget a little more than 36%? You could, but it may negatively affect your interest rate. Most banks don’t like to make loans to borrowers with bad debt-to-income ratios, and they may ask for a little more from you to give you the loan.
Whatever method you use and number you settle on, most advisers agree on the following points:
- Cash reserve: You should always try to keep at least three months’ worth of payments in the bank in case of an emergency. Banks like to see it, and it should be considered your personal insurance policy in the event of unexpected repairs or problems.
- 20% down payment: Although that can be a big chunk of change, if you can afford to put 20% down, you benefit in multiple ways. Instant equity is built protecting you from any minor market downturns. You obviously reduce your monthly payment, but you can also avoid paying for private mortgage insurance (PMI). Most importantly, you improve your chance of getting the loan in the first place.
In the end, choosing a home should be based on a real understanding of your personal financial situation. Taking the time to crunch numbers may not be that exciting, but it certainly can help you set realistic limits that will make finding and negotiating for a home easier.