As my wife and I consider our options when it comes to selling our current home, and building our dream home with my in-laws (who are home builders), one thing we've been thinking about quite a bit is just how much home we can afford.
There are several lines of thinking when it comes to buying a house. Some will say you should only buy a home that is below a certain percentage of your gross or take home pay. Others will say you shouldn't buy a home that is more than 2-3x your annual income. Still others think you should rent and do your best to save up for a home and only buy when you can pay with cash. Of course, on the other end of the spectrum there are those that say it's OK to buy a home above your means as you'll grow into the payments as your income increases.
There is no shortage of advice when it comes to figuring out how much house you can afford. Let's take a look at some expert opinions, figure out what banks will approve you for, and figure out what is usually the most financially sound decision to make when buying a new home.
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How Much House Can You Afford: Expert Opinions
So what do the experts say when it comes to how much house you should buy? The advice varies depending on who you go to.
Dave Ramsey says that there is no magic formula to figure out how much house you can afford, because it depends on a lot of secondary factors:
There is no magic dollar amount for the “perfect home.” How much house you can afford is as unique as you are and is based on many factors—your location, income, savings, personal preferences, and most importantly, the house-buying plan you have in place.
The ideal way to buy a home is the 100%-down plan. Sounds weird, doesn't it? But think how much fun that would be. No mortgage! No payments!
If you can't postpone the purchase until you can pay cash, buy a home with a down payment of at least 10% on a 15-year (or less) fixed-rate mortgage. Limit your monthly payment to 25% or less of your monthly take-home pay.
Ramsey says you should put down as much as you can on your home purchase, prefers a shorter term mortgage, and says you should try to keep your payment below 25% of your take home pay. Think nobody pays cash for a home like Ramsey suggests? An article from last year on WSJ.com said that fully 28% of home purchases were cash transactions in the previous year.
David Bach says most people can afford a house anywhere from 29-41% of their gross income, depending on whether they have other debt.
When it comes to buying a home, the bottom line isn’t how much houses cost. It's how much you can afford to spend. Most people can afford to spend 29 percent of their gross income on housing costs- including the mortgage payment and property taxes- and as sometimes as much as 41 percent, if they have no debt. You should also consider your other savings goals, medical expenses, ongoing household repairs and maintenance, and even how secure your job is. Once you calculate your magic number, play it safe by knocking off an additional 10-20%.
Bach also mentions that it's a good idea to keep it on the lower end of what you can afford by knocking 10-20% off of what you can afford once you come to a percentage. So if your gross income is $5,000/month, then your mortgage could be anywhere from $1450-2050 before knocking off 10-20% of that payment to come to a final number.
Thomas J. Stanley
In his book The Millionaire Next Door, Thomas J. Stanley gives one quick home buying rule if you want to grow wealth like the millionaires he studies:
Here is another one of our rules: If you're not yet wealthy but want to be someday, never purchase a house that requires a mortgage that is more than twice your household's total annual realized income.
So Stanley suggests that you should never have a mortgage that is more than twice your annual net income. So if you have a realized income of $100,000/year, you shouldn't be getting into a mortgage that is any more than $200,000. So if you put down a $40,000 down payment, you could afford a $240,000 house on your income.
Suze Orman has a bit of a different approach to the problem. She suggests that people figure out what they're currently paying for rent, add 45% to it to account for taxes, insurance and other home ownership costs, and then start paying your rent and then saving the extra 45% for a few months along with all of your other regular bills and saving. If you can do it without too much problem you could then consider home ownership. If not, avoid buying until a time when you can make those payments easily.
What Banks Say You Can Afford
Banks have their own way of figuring out how much house you can afford – or how much they're willing to risk by lending to you. Usually it involves figuring our what your debt to income ratio is.
- Front end DTI of 28%: When figuring out how much of a loan to approve you for, banks will figure out what your front end debt to income ratio is. In general they'll want you to be at a DTI of 28% or less. To figure out what yours would be you take the potential cost of your monthly mortgage payments, taxes and insurance and divide it by your monthly income.
- Back end DTI of 36%: Banks will also want your back end DTI to be less than 36%. Back end DTI is like front end, except that it also includes any other monthly debt obligations beyond your mortgage – things like credit cards, student loans, etc. To figure out what yours would be you take the potential cost of your monthly mortgage payments, taxes and insurance, and then the rest of your debt obligations and divide it by your monthly income.
So banks are usually willing to lend people money that will give them a debt to income ratio of anywhere from 28-36%, depending on whether all debts are factored in.
Home ownership costs don't begin and end with the mortgage payment. There are a host of other costs you'll need to take into account when buying your new house, and figuring out how much you can afford. Here are just a few:
- Property taxes: property taxes can be a huge yearly cost, depending on how much your home is worth, and where you live. Where we live yearly property taxes are around 1%-1.5% of the home's value.
- Insurance: Homeowner's insurance is another cost you'll need to take into account. For us it comes out to another $80-100/month.
- Private mortgage insurance: If you weren't able to put down 20% on your new home, you may be required to pay PMI. That can be $100-200 or more per month added to your payment.
- Association costs: If your new home is an association run neighborhood, you can expect monthly dues payments. Our current association costs us $149/month.
- Lawn care: If you have to do your own lawn care it can be an added cost every month.
- Utilities: The bigger the house, the more you'll usually have to pay for the utilities. Bigger houses cost more to heat and cool!
- Maintenance: If it's an older house it may require more regular maintenance, something to take into account.
- Distance from work: If the home is further from your work, your commuting costs may be higher.
When you add all these things (and other things) up, it can be hundreds of dollars more per month you'll have to pay beyond your mortgage payment. Something to consider when you're figuring out how much you can afford. For a more exhaustive list, check out this article in the New York Times.
Buy Less Than You Can Afford If You Want To Build Wealth
So with all the numbers in this article, should you even really spend what you can afford? Or should you be spending less than your means if you also want to build wealth?
As Thomas J. Stanley mentions, the millionaires he studied weren't known for living lavish lifestyles, but instead for living below their means. Even though they could afford it, most millionaires live in average neighborhoods, in sub $300,000 homes.
There are nearly three times more millionaire households [1,138,070, or approximately 28.3% of the total, versus 403,211, or about 10% of the total] living in homes valued at $300,000 or less than there are millionaires living in homes valued at $1M or more. The data strongly indicate that this ratio of wealth building productivity is inversely related to the market value of one's home.
When purchasing their first home, he also found that the median ratio of annual income to home price for millionaires was 1.49. So for millionaires their first home purchased was no more than 1.49 times their annual income. I don't think most folks these days can say that.
What We'll Do In Our Situation
We're still figuring out what we'll do in our situation, but for now we're putting our home building dream on hold so that we can save up a bit more cash before we buy. We want to have at least a 20% down payment, and with our current home's value going down the tubes, it means we won't be getting much of anything back when we sell our home.
I'm the more conservative one in our marriage and I'd prefer to keep our debt to income ratio below 25% as Dave Ramsey suggests. Currently it's down below 20% with our current mortgage being our only debt. If we were to buy our dream home, my father in law has already calculated what it would cost to build that home, and it would give us around a 24-25% debt to income ratio, so well within the range that most say you should be in. Still, it will be more than 2 times our annual income as suggested by Stanley if you want to be a millionaire next door, closer to 2.5 times. Maybe we should wait a bit longer and save up a bigger down payment?
What are your thoughts on how much house someone can afford? How much should someone's house payment be to keep themselves in a good financial situation?