Is it time to step out the apartment life and into homeownership? After renting for years you may have found yourself ready to have your own place, away from noisy wall-sharing neighbors and crazy landlords. But you might not be sure if you’re ready to sign your life away for the next 30 years without having money left to live like a normal person. To make sure you don’t find yourself eating rice and beans for every meal for the foreseeable future you need to determine how much house you can afford.
A Little Background
Historically, banks have used a seemingly absurd ratio (explained below) to help them compute who could borrow from them and how much each borrower could borrow. The issue with the ratio banks use has always been that the information presented by home buyers has been loosely verified, they ignore reasonable living expenses, and they exclude income taxes. Even though the banks may allow you to borrow up to a certain amount, that doesn’t mean that you should.
The Ratio Rules
Banks love to use ratios & percentages to quantify what people can afford to do. A guide that they use in determining what you can afford is the 36% rule. This states that your combined debt (credit card and any loans, school, car, etc.) and projected house payments (mortgage, property taxes, and homeowner’s insurance) should not exceed more than 36% of your pre-tax (gross) income. This is known as your debt-to-income ratio. The table below illustrates a basic example of how this rule can be applied.
Banks become hesitant to loan to borrowers with more than a 36% debt-to-income ratio because of the ability to be able to pay a mortgage drops the more that you owe to others. Thus, if you keep the 36% rule in mind, you will be more likely to find success in securing the loan on a new home purchase. It is always a good idea to pay off any extreme amounts of debt prior to the loan application process to be as prepared as you can be to make the commitment to paying for your home.
Down Payments & Cash Reserve
In an ideal world you will be able to pay 20% of the home value in a down payment. The larger the down payment, the smaller the loan, thus the less you will pay overall due to a decreased interest payment and a possibly shorter loan term. This also reduces the likelihood for primary mortgage insurance (PMI).
It is also recommended that you try to save three months of living expenses as a cash reserve prior to purchase. Although keeping your debt-to-income ratio low secures short term protection, when it comes to financial changes, a cash reserve can help you in the long-run when the unexpected occur such as an “involuntary termination” from your employer or a dreaded home repair or unexpected medical bill.
So How Much Can I Really Afford?
I’m not going to give you a quick equation to figure out how much house you can afford. Instead, I’m going to advise that you sit down and reverse engineer the amount that you can afford. Homeownership requires more cash dollars but typically has longer-term financial benefits. Still, if you can’t afford to make the payments each month and have a quality of life, then why do it? Generally speaking, you should consider the following in your calculation:
- Income (specifically take-home pay after income taxes)
- Existing debt including auto loans, student loans, personal loans, medical bills, etc.
- Child expenses, including childcare (if they apply)
- Food, clothing, fuel, insurance, and other personal expenses
- Utility costs
- Retirement savings
Once you have mapped out your income minus your expenses, whatever you have left over is a realistic amount that you can spend on your monthly mortgage payment, homeowners insurance, and property taxes. Factors that should be considered when determining how much you can afford are:
- Down payment and savings
- Mortgage term
- Interest rates
- Private mortgage insurance
- Property taxes
- Homeowner’s Association Dues (if they apply)
- Local real estate market
- Your credit score
My final thoughts; don’t over-commit yourself because a real estate agent tells you that you can afford your dream home, or because a bank will approve you based on a magic number. There is no need to keep up with the Jones' anymore. Do a little legwork and calculate the amount that is comfortable for you to afford. If the answer you calculate doesn't put you in a practical home today, then wait. You can always purchase a house later on. Even if you can't your dream home the first time you can always start with something small today and upgrade in the future. There is more than one way to approach homeownership, just don’t screw yourself!