Back HomeHow Much Home Can You Afford?
February 16th, 2011 by keithandkinseyThere’s many different theories on how much home you should buy. Some experts say leverage yourself to the max, others say limit your mortgage to a 15 year loan with payments less than 25% of your take home pay. My opinion tends to be somewhere in the middle of these two theories but a little closer to the conservative side. I don’t ever want to see one of our clients lose their home because they spent more than they could really afford. So, I’ll walk you through a step by step approach that works fairly well.
Step 1: Talk to a mortgage lender. You need to find out a ball park idea of interest rate, private mortgage insurance (PMI), and closing costs. This is all based on your credit, income, current debts, and the down payment you have available. Don’t be afraid to ask about different scenarios such as 15yr loan vs 30 yr loan or 5% down programs vs 20% programs. You will avoid PMI if you put 20% down.
Do not ask the lender how much you can afford. They will probably tell you anyway, but their number is too high. The lenders calculation of affordability is a debt to income ratio (DTI) that is based on your gross income (pre deductions) rather than your net income (post deductions). The standard conventional loan ratio is 36% for total debt and 28% for mortgage debt, with some loan programs going up to 41% DTI (or higher). I don’t agree with this because most of us pay taxes, health insurance expenses, and 401k contributions before we arrive at our take home pay. On my last paycheck, I only took home 59% of my gross pay. So, if my loan payments were 41% of my gross income, they would actually be 68% of my net income. This would leave me only 32% of my take home pay to pay my utility bills, put gas in the car, save for the future, and put food in my stomach. YIKES!
Note: If you’re not contributing to retirement, you should be contributing 10% of your annual income before purchasing a home.
Step 2: Look at property taxes and insurance. You don’t know your exact price range yet, so look online at a range of houses in your area to get an idea of what you’ll be paying in property taxes. If you can’t find this online, don’t hesitate to call a real estate agent and ask for help. Also, call your insurance agent and get an estimate on what insurance would cost for houses that you are looking at. Combine these two annual numbers and divide the total by 12 to get a monthly rate.
Step 3: Total up your expenses: Add up everything you spend in a month in two different groups.
Group A is everything you typically spend money on in a month other than loan payments and housing expenses. This list probably includes: food, utilities, fuel, travel, clothing, savings goals, entertainment, car insurance, charitable giving, and much more. Ideally 20% of this should be savings.
Group B is loan payments such as cars, credit cards, or student loans. I highly recommend paying these off before you buy a home (especially the credit cards). However, I’ll let you slip by with a little extra debt.
If you’re wondering where all your money goes and you don’t have a good feel for your spending. Consider using something like Mint.com to categorize and track your expenses for a few months prior to making any house buying decisions.
Note: Plan for your future with your spending calculations. For example, if your planning to have kids but don’t currently, factor in day care, diapers, and children’s clothes.
Step 4: Total up your income. Add up your monthly income after deductions. Include all your regular monthly income and your spouses income if you’re married. Again factor in your future. If your spouse plans to quit his or her job after having children, don’t include that income in your calculation.
Note: If you get a huge tax return at the end of the year, consider adjusting your withholdings so that you don’t get a tax return. A tax return is a interest free loan to the government. By making a withholding adjustment, you can increase your take home pay, and reduce your tax return.
Step 5: Compare income vs Expenses. Compare your expenses from step 3 group A with your income from step 4 and see where your at. For most of us our group A expenses are probably less than 50% of our take home pay. If your group A expenses are more than 50% of your take home pay, you probably need to be a little more frugal, or spend less on a home.
Now consider the remaining 50% of your take home pay. This can be allocated to debts and mortgage. Don’t let your total debt payments (including property taxes and home owners insurance) exceed 50% of your take home pay. The conservative side of me says shoot for less, like 35-40%. Of course, if you’re extremely frugal with your other spending, or you have a very high income, you can adjust this how you see fit.
Note: Since you are combining all your debts in this number, you can clearly see that being debt free is a big bonus when buying a home.
Example:
4.8% interest on a 30 year fixed rate loan (from step 1)
$10,000 down payment (from step 1)
$2,000 in closing costs (from step 1)
= $12,000 of money up front
$3,000 per month take home pay (from step 4)
$1200 per month in expenses (from step 3 group A, note it’s less than 50% of the income)
$1,500 per month available for loan payments (from step 5, this is 50% of step 4)
-$200 per month car payment (from step 3 group B)
-$100 per month PMI (from step 1)
-$300 per month taxes and insurance (from step 2)
=$900 available for actual mortgage principal and interest.
Using a mortgage calculator we can see that this person could afford:
$181,500 house (your loan officer probably told you you could go up to $230,000)
$10,000 down payment
$171,500 loan
Using my more conservative numbers of 40% this person could afford:
$134,000 house (again your loan officer probably told you you could go up to $230,000)
$10,000 down payment
$124,000 loan
Every person has a different situation. If you have several kids you probably want to be more conservative. However, if your never planning to have children you could probably be a little more aggressive. The main point is, think it through, look at your specific situation, look at your future, and don’t lie to yourself about what you can really afford.
