By Brandon Cornett | © 2014, all rights reserved | Duplication prohibited
Reader question: "My husband and I are planning to buy our first home this summer. Between the two of us, we make about $115,000 a year. We both have pretty good credit. How much house can I afford to buy, based on these things? Is there a certain percentage of my income that I should be aiming for? Any input would be most appreciated."
You've left out some important pieces of the puzzle. In order to answer your question (or even give you a ballpark figure), I would need to know the following:
How much do you spend each month on your other debts? How much do you spend on lifestyle expenses? Are you willing to sacrifice some or all of those lifestyle expenses? Do you currently contribute money to a savings and/or retirement account? How much of a down payment can you afford?
You can see how many variables are at work here. So instead of telling you how much you can afford, I'll show you how to determine this for yourself .
Some "experts" advise home buyers to use a certain percentage of their income as a guide. I see 33 percent mentioned a lot. The idea here is that you should spend no more than 33 percent of your monthly income on housing costs. But this is a flawed concept. The main problem with this approach is that it doesn't take your other debts and expenses into account. This is not the best way to find out how much house you can afford. It's better to subtract your monthly expenses from your income, and then work down from that number.
My advice is to forget about some arbitrary percentage. Instead, get out a piece of paper and tally up your monthly expenses. Include everything from bills to luxuries. Allow for a monthly contribution to savings or retirement. Factor in a buffer zone for emergencies. Subtract this from the money you take home each month, after taxes, and you'll know how much house you can afford to buy.
Video Lesson - How Much Can I Afford?
If you're the kind of person who learns by watching rather than reading, you'll like this video. I made this video for a website called SketchNest.com. It basically covers the same concepts explained in this article, but with illustration and narration. It answers the question: How much of a house can I afford to purchase?
This video offers a hypothetical list of monthly expenses. But you may have additional expenses that are not mentioned in the video. College tuition, alimony and child support are good examples. The key is to tailor the strategy for your particular situation. If you can't remember exactly where your money goes each month, or how much you spend, refer to your bank statements and credit card bills. This will show you where the money goes.
At a minimum. your list of monthly expenses should include:
- Car payment and auto insurance payment
- Credit card payments and other monthly loan payments
- Any ongoing medical costs you have
- Life and health insurance premiums, if applicable
- Grocery costs and other shopping expenses
- Whatever you put toward savings and retirement each month
- Lifestyle / entertainment expenditures (dining, hobbies, vacation, movies, etc.)
The Problem With Percentages
The following scenario shows why percentages aren't very useful in this process:
I want to know how much house I can afford to buy. I visit a website that tells me not to spend more than 33 percent of my income toward my mortgage payments. I make $6,000 a month. So 33 percent of this would be $1,980. This leaves me with about $4,000 left over each month, after my mortgage payment.
I also have a student loan that I'm paying back, and that equals $275 per month. My car payment is $450 per month. My credit card bill is around $250 per month. I spend about $450 a month at the grocery store. My utilities run about $150 per month. Then there's the additional expense of lifestyle and entertainment (hobbies, dining out, etc.).
This doesn't leave me with very much money left over each month. What if my car breaks down and needs a major repair? What if I incur some medical bills? What if I want to save for retirement or my next vacation? Can I still afford these things, given my new mortgage payment? Or has my new home made me house poor?
The problem with percentages is that they don't take the borrower's unique situation into account. For instance:
- How much does the borrower contribute toward savings each month?
- How much does the borrower spend on other debt obligations?
- How stable is the person's income stream?
- Is it a two-income family, or a single (and more vulnerable) earner?
To be useful, the recommended percentage of income would have to be scaled up or down, depending on the borrower's situation. Every borrower is different. It's much better to start with your current monthly expenses and work backward toward your housing budget.
Mortgage Approval and Affordability - Two Different Things
First-time home buyers often put too much faith in their mortgage lenders. Perhaps it's more accurate to say they don't fully understand the lender's role. If you want to answer the question, How much of a house can I afford, you need to look to yourself. The lender cannot tell you this. It's neither their job nor their responsibility.
The only thing a lender can tell you is:
- Whether or not you meet their minimum guidelines for approval
- How much of a mortgage loan they're willing to give you
- How much your closing costs will be
- What kind of interest rate they are offering
But nothing in this list says what you can actually afford to spend each month. You must calculate your own financial comfort zone. And it's imperative that you do. Why? Because mortgage approval and affordability are not the same thing. Believe it or not, you can be approved for a loan that stretches your budget to the max -- and beyond.
Don't believe me? Just ask the millions of Americans who get foreclosed on each year. Sure, some of them didn't encounter problems until after they took on the mortgage debt. But just as many of them were doomed from the start. They took on more than they could realistically afford.
A Dirty Little "Secret" of the Mortgage Industry
I've repeatedly said that it's possible to get approved for a loan that's too big for you. You might
wonder how this is possible. "The lender wants to make sure I'm comfortable with the size of my payments, because they have a stake in it. If I can't make my payments, they lose money. Right?" Not always. Lenders can sell their loans into the secondary mortgage market, within days of making the loan. So they make a profit from the loan while avoiding any long-term risk associated with it.
This if why lenders often require you to have cash reserves in the bank. This is money above and beyond what's required for your down payment and closing costs. A typical requirement is to have two or three month's worth of mortgage payments in your savings account. The lender wants to ensure you can make your first few payments, while they still have the loan. Beyond that timeframe, they will probably have sold it into the secondary market.
There are tougher regulations of the lending industry today, as a result of the housing crisis. But lenders are still permitted to sell most of the loans they make, and this removes the long-term financial burden from their shoulders.
What's my point? The point is you cannot view your lender as a financial advisor. They only care about your financial stability as far as they plan to keep the loan. This is why it's possible to get approved for a mortgage payment that exceeds your comfort zone. You need to determine how much house you can afford before you start talking to lenders.
Start at the monthly level, and work upward from there. Set a monthly budget (an absolute spending limit), and then find a price range that coincides with that limit.
Housing Budget First, Pre-approval Second
Mortgage pre-approval is a helpful step during the home buying process. I recommend that all home buyers get pre-approved by a lender. before shopping for a house. This is when the lender reviews your financial situation to determine how much they're willing to lend you. This will help you narrow your property search to the types of homes you can afford. It will also help you get a real estate agent on your side (most agents will only work with buyers who've been pre-approved by a lender).
But there's an important distinction to be made here. Pre-approval does not tell you how much of a house you can afford. It does not take your financial planning into account. The lender simply looks at your current income, debts and credit score, and then gives you a maximum amount. As I stressed earlier, you might get approved for a loan that exceeds your personal budget.
What to take away from this: Getting pre-approved is worthwhile. But you should already have a budget on paper, before you start talking to lenders.
Do Mortgage Calculators Tell Me What I Can Afford?
A mortgage calculator can handle most of this for me, right? Wrong. Mortgage calculators are not "smart" tools. They do not include any of the variables we've discussed in this article. The only parameters they include are the mortgage amount, length of the term, interest rate, and (sometimes) property taxes and insurance costs. They are not designed to tell you what you can afford to spend each month. They are designed to take a specific loan amount and break it down into monthly payments -- that's all.
Don't get me wrong. These calculators are useful in their own right. It's best to use them after you've established a budget of your own, and after you've been pre-approved by a mortgage lender. That way, you can figure out if a certain home falls within your budget. The calculator will tell you what the monthly payments might be, based on the information you provide.
Here's an example of using a mortgage calculator to connect the dots:
I create a housing budget for myself, as explained earlier. This process helps me identify my monthly limit. The most I'm comfortable spending toward a mortgage payment is $2,500. A mortgage lender pre-approves me for a loan of $500,000 and offers me an interest rate of 5 percent. I plug this loan amount and interest rate into a mortgage calculator, and it tells me that the monthly payments would be around $2,680. And this doesn't even include property taxes and insurance. I've been pre-approved for a higher amount than I'm comfortable spending. This should raise a red flag in my head.
Here's what I would do next in this scenario:
- I have two spending limits here. I have my own housing budget, in addition to the pre-approval amount. Remember, these two numbers might be different.
- For house-hunting purposes, I need to stay within the lower of these two limits. My budget is the lower number. I'm not comfortable spending more than $2,500 a month on a mortgage.
- The lender has pre-approved me for a home loan up to $500,000. But the monthly payments on a loan that size would fall outside my comfort zone.
- So. I would use a mortgage calculator to figure the monthly payments for lower home prices (below $500,000).
- Hint. Try to find a calculator that has parameters for taxes and insurance. The estimated payments will be more accurate.
- After some trial and error, I enter $450,000 into the mortgage calculator. It tells me my monthly payment (based on a 30-year loan at 5 percent interest) would be $2,415. This number is within my budget! Even if I added a couple of hundred dollars more for taxes and insurance, it's still close to my $2,500 monthly target.
Now I have several pieces of the puzzle. I know how much house I can afford to buy, because I've established a budget . I know how much the lender is willing to give me, because I've been pre-approved . And I have a price range for house-hunting purposes, because I've done some trial and error with a mortgage calculator . Budget. pre-approval. calculator. This is how it all comes together.
Do a Google search and you'll find plenty of free calculators online. Most banking, lending and financial services websites offer these tools as well. Bankrate.com had some nice ones, the last time I checked.
More Tips on Buying a House
I hope this information helps you understand the budgeting process when buying a home. You'll also be happy to know this website offers more than 1,000 additional articles on the home-buying process. Many of these articles deal with the same question you asked above: How much house can I afford, based on my income? Use the search tool at the top of this page to continue your research, or use the articles I've recommended below.
Good luck with your buying process!