20% Down Payment + 10 Years
Personally consider these as the conditions that you must meet before you even think about buying a house. You should be able to pay the 20% down payment from your savings, and plan to stay in the house for at least 10 years. If you can pay the 20% down payment from your savings, it shows that you have healthy positive cash flow, which allowed you to save up the money in the first place. If you do not have the pre-requisite savings, you should consider cutting your expenses and increasing your income to save up for the down payment before plunging into homeownership.
The 10 years portion is simply to help increase the likelihood that you will come out financially ahead after factoring in the costs of buying, selling, and living in your home. If you are planning to stay in your house for less than 10 years, you should consider renting instead.
3 Rules of Thumb
Up to 3 Times Your Annual Gross Household Income
The first rule of thumb is to take your annual gross household income — basically, the money you and your spouse make in a year before taxes — and multiply that by 3. For example, if you earn $40,000 a year and your wife earns $50,000 a year, your household income is $90,000 and you can afford up to a $270,000 home.
This is a quick way of calculating, but the main problem with this rule is that it doesn’t take into account your other debts.
Housing Related Payments Less Than 28% of Your Monthly Gross Household Income
The second rule of thumb is that your monthly housing related expenses (i.e., mortgage payment (principal + interest), real estate taxes, and homeowner insurances) should be less than 28% of your monthly household income. From the example above, your monthly income is $90,000 divided by 12, or $7,500 per month. Therefore your monthly housing expenses should be less than $2,100 ($7,500 x 28%).
Using a mortgage amortization calculator, $2,100 a month will buy you a $300,000 home at 5% 30-year fixed mortgage rate, assuming your real estate taxes and homeowner insurance is less than 2% of the purchase price, e.g., $6,000 per year.
Total Debt Payment Less Than 36% of Your Monthly Gross Household Income
The third rule of thumb is similar to the one above, but this rule takes into account all of your debt obligations such as student loan payment, credit card debt payment, and any other debt that you may have. From the example above, 36% of $7,500 is $2,700.
The rule is a nice way to double check other rules. For instance, if you are making a $500 car loan payment a month, $250 student loan payment a month, and another $750 payment toward credit card debt; then you only have $1,200 left for house payment — this means you can only afford a $170,000 house and not the $300,000 house from the previous example.
This is why it is important to limit the amount of debt with respect to your income before adding more debt — i.e., a mortgage — to your budget.
Mortgage Pre-Qualification
A second method of determining how much house you can afford is to go directly to the lender and ask for a loan pre-qualification. Many lenders have online application that you can fill out in less than 10 minutes. After you fill out the pre-qualification application, a representative will call you for addition information and verification. Usually, you will find out the same day the following information (1) the amount of loan that you are qualified for, (2) the estimated interest rate (this rate is “floating”, meaning it is subject to change), and (3) the estimated closing cost. Also note that this process will cause a hard pull and will likely lower your credit score for about 3 months.
The pre-qualification is usually good for 90 days, however, the final loan approval is subject to sufficient proof of income and asset.
Simulate Your Mortgage Payment Experience
The problem with all the methods mentioned above is that they do not take your financial habits into account. So what is the best way to answer this question: How much house can I afford?
The best answer is to simulate your home ownership experience — test drive it! For example, let’s say you’re paying $1,300 a month in rent today, and you’re looking at a $1,500 monthly mortgage payment. To be conservative, we’re going to add a 20% premium on top of the mortgage to account for homeowner’s insurance, real estate taxes, private mortgage insurance (PMI), maintenance, and additional utility costs, for a total of $1,800.
Are you ready for a test drive?
It’s easy. Since you’re paying $1,300 in rent, all you have to do is save the $500 difference each month. The best way to do this is to put the money into a separate savings account that pays a decent interest rate. You should do this for at least a few months to see if you can adjust to the new lifestyle.
- If you have no problem with the extra savings — That great! You’re financially ready and the extra money saved can go toward your down payment or emergency fund.
- If you find yourself making compromises to hit the savings goal — Then you are going to be "house poor". You should look for a less expensive house, find more ways to trim your expenses, or look for ways to increase your income. You don’t want your house to become a financial barrier to achieving your other goals.
- If you are struggling to consistently save the difference – Then you should reevaluate your homeownership goal and financial priorities. May be a less expensive house, or a more frugal lifestyle is the solution, may be not.
Buying and owning a home is an exciting experience, but it’s not always the right choice for everyone. For home ownership to be rewarding the house should be both physically and financially comfortable.
If you find that you are in the market for a new home at the lake, please contact the Spouses Selling Houses team and let us go to work for you. Until next time!! Ebbie :)
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