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.
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.
Don’t Forget The Hidden Costs Of Home Ownership
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?
William @ Drop Dead Money says
I like Suze Orman’s approach, and I think you’re wise to wait till the next recession. Here’s a mental mindset (is that a redundancy?) trap to be aware of:
Most people find it hard to sell their house at the bottom of the market because they’ll “lose money.” That’s a fallacy. When you trade from one house to another, you never gain or lose. The house you’re buying also went down (or up), so all you’re doing is trading. The general rule is: when trading up (getting a more expensive house) you want to do that at the bottom of the market. If you’re trading down (like empty nesters) you want to do that as close to the top of the market as you can.
In general, housing is an expense. Over our lifetime, most of us pay more in insurance, interest, taxes and maintenance than for the house itself. Therefore, the lower we can make the house cost, the more we’ll have left for our drop dead money (enough money that we can tell our bosses to drop dead – just a fun term for retirement).
Here’s an interesting factoid I came across: A little over fifty years ago, our parents/grandparents lined up (literally) to buy Levittown houses. This was the first housing tract (in New York) and it offered affordable housing for the first time. It was so popular the creators were featured on the cover of Time magazine (I think it was in 1951 or so). Anyway, these houses had one bathroom, no garage or basement, and they were just over 900 square feet. Those folks did all right.
I’m not suggesting we all go back to that, but it does show how our expectation for housing has risen, and with it both the cost… and a reduced expectation for retirement. That’s no coincidence.
Just something to keep in mind… :)
Christina @ Northern Cheapskate says
We built our dream home in 2005. No matter how much you budget or try to be conservative, building a house always ends up costing more than you think. In the end, our house payment is about 28 percent of our income. It was fine in 2005, but my husband hasn’t had a raise since then, we now have 3 kids instead of one, and the cost of everything from groceries to gas has gone up.
I love my house, but if I had to do it all over again, I would have been MUCH more conservative.
Peter Anderson says
I agree, homes usually end up costing so much more than you think they will, both in the construction portion, and in the costs after the purchase.That’s why I think Suze Orman’s idea to add 45% to the mortgage payment isn’t a bad idea – it means you’ll be expecting those extra costs and be ready for them.
On David Bach’s advice, I think you made a math error in your comment:
That would put him more in the 20-30% of gross income range.
He suggested anywhere from 29-41% and then drop it down 10-20%. Say someone’s income is $3,450/mo, 29-41% would be around $1,000-$1,415. 10-20% off those would be $800-$1,275, which would be about 23%-37%.
That being said, I think 20-30% is a better figure to use.
Also for MND:
twice your household’s total annual realized income
That is twice your net (realized) income. If someone makes $100k/year but nets only $80k/year, that would be a $160k mortgage instead of a $200k mortgage.
I see so many people playing the wrong side of the numbers. They stretch it to get as much as they can instead of playing the safe side (net vs gross income). I recommend their payments be no more than 20-25% of their net income, and get a 30 year and pay on it like a 15 year. It’s a higher interest rate (which equates to around an extra $40/mo for every $100k), but if they have a financial crisis, they can drop down to a 30 year payment (cutting an extra $250 from their expenses each month). Many people who go bankrupt an extra $250/month could have prevented it.
Peter Anderson says
Thanks for pointing that out.That’s what I get for writing so fast and just whipping numbers out there without double checking what I’m reading first. I think I’ve fixed it up above now.
I think more people would be better off to base the numbers off of net income, and stay below their means and keep it 20-25% on the top end.
Excellent article, Pete. It took a little leg work to put this together, but it’s great to investigate what different people say about this topic. I think too many people fall in love with the idea of home ownership and look at the costs with rose colored glasses. Home ownership is the largest expense most people will ever have, so it pays to be conservative with it.
Peter Anderson says
Agreed, being conservative with home ownership costs is the best route to take. Otherwise it can short circuit long term gains when you don’t have enough extra left over to save, invest and give.
Zach @ Milk and Honey Money says
I think keeping your payment at or below 30% of gross income is a good rule-of-thumb. If you can go lower and find a place that you like, even better!
Saving at least 30% of the purchase price sounds like a good goal. Then you can put down 20%, but still have some savings just in case.
There’s a lot of factors involved though. Here in Southern California, it’s almost impossible to buy for 1.5-2x your annual income!
Yes! This is why we haven’t purchased anything yet. I think a large portion of people in Southern California are paying closer to 50% of their net monthly income on their mortgage. It’s a dangerous game to play, but hopefully it helps to drive the price down a little lower.
Zach @ Milk and Honey Money says
I was 100% against buying here until about a week ago when my landlord informed me I need to move. After looking at current rent prices, I was getting a better deal that I thought!
Running the numbers (for me at least) shows even with these high purchase prices, its going to be cheaper for me to buy than rent. I’ll just have to continue living frugal with my other expenses.
What city were you in? I’m in Anaheim and the rent for my 1 bedroom apartment (750 sq ft) is $1200. We are currently saving up to move into a house but it probably won’t be until 2014 or 2015.
Zach @ Milk and Honey Money says
I’m living in a small town in the Santa Barbara area. I’m coming up with a price to rent ratio of about 15 around here. With interest rates at all time lows and my current tax situation, it seems like the time is right for me to buy.
Keep on saving! Who knows, real estate might continue to drop for another few years.
How interesting that a new post 5 years later brings me back to this article.
For anyone interested, that same $1200/month apartment now rents for $1625/month 5 years later. Fortunately for us, we bought a house in early 2017 and don’t have to sweat rising rent prices any longer :)
Roger @ The Chicago Financial Planner says
Great post a lot of good expert opinions for folks to consider. I fully concur with buying less home than you can afford. This has always been true, but it has been reinforced during the recent economic downturn and the continuing lousy housing market.
DC @ Young Adult Money says
In reference to Ramsey -> “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. ”
-Totally disagree with him. I personally think inflation is a lot higher than the interest rates right now. Lock in for 30 years in a house big enough that you will be okay not selling for at minimum ten years. That’s my opinion, at least. You make money over time (assuming the dollar continues to devalue faster than the interest rate) by locking in at these low interest rates.
“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.”
-I wonder how many of these were investment purchases…..
Peter Anderson says
I like the idea Marc mentioned above – getting a 30 year mortgage, and then paying it like it’s a 15 year mortgage. You get the added flexibility, and the benefits of having a 15 year if you’re able to pay it off early.
I’m guessing that a good majority of those cash purchases were for investment purchases, the article does mention that every time the economy drops or worsens, the number of cash purchases goes up.
Anything above 20% down is considered cash purchase.
Manette @ Barbara Friedberg Personal Finance says
One of the most reasons why we are having difficulty looking for the new house we have been wanting to buy is budget. We are allocating maximum 25% of our income for our mortgage. The additional 5%-10% will be spent for tax, insurance, and association dues though we are not expecting our electricity and water bills to increase much.
Looking at the cash flow side of the equation is just half the story. Credit conditions make up the reason why your proposed house is more than 2x income even though the debt to income ratio is ok. I would wait out a bit until there is some semblance of sanity in the credit markets before moving forward, otherwise there is a real likelihood of taking a large capital loss in case you had to sell for some reason.
A lot of this depends on your situation in life. When my wife and I started looking for our first home, we had a combined household income of $65,000. Now, a year and a half later we make $115,000. The house we ended up buying was $210,000, which seemed like we were really stretching our budget at that point. These days, mortgage payments are easy to make. I work in one of the few industries right now that is booming and is desperate for talent, and have been increasing my marketability by obtaining a masters degree.
Do I wish we had opted for a bigger, better house? No, not really. I like the peace of mind of knowing I can pay the bills with some change to spare. “Less is more”…
“An article from last year on WSJ.com said that fully 28% of home purchases were cash transactions in the previous year.”
There’s a reason why people can pay cash, and most of them do not have anything to do with ordinary American families: A) There are high-income earners of the top 1%-5% variety who can and do buy homes all-cash, B) the cash buyers consist of home flippers, and C) the all-cash homes are increasingly being sold to foreign real estate speculators out of China and Russia (the NYT did an investigative piece that took them two years to complete because the ownership trails hide behind LLCs of various kinds.)
I respect Suze Orman’s 45 percent rule-of-thumb when it comes to budgeting for a house vs. apartment. That said, I really take issue with a number of Dave Ramsey’s over-optimistic assumptions. Case-in-point: Ramsey’s current budget example in response to Googling “How much home can I afford” uses $6,000 combined (dual) monthly income as a starting point. Googling “American households earning six-figure incomes” the answer, from Bloomberg, is about 25 percent. So right off the bat Ramsey’s advice is tailored to what only a quarter of his readers can apply to themselves.
As an example of how much the “real world” can deviate from over-optimistic examples, take the Greater Los Angeles region. Southern California, as a whole, is among the highest housing cost areas to live relative to incomes. Median earners only earn about $55K a year, whereas nationally the number is only about $53K. And yet in the Greater Los Angeles area 50-year-old homes and even condos are six-figure acquisitions.
If renting is said to be the more financially responsible thing to do, think again. The average one-bedroom apartment per news reports out in early 2017 has hit over $2,000 per month due to a years-long multifamily housing shortage and the fact that so many people who were displaced from their homes during the financial crisis are competing in what was already a tight rental market. As a result, LA area renters, as of 2014, were reported to spend as much as 47 percent of their incomes on housing per UCLA, USC and others who track housing trends. Los Angeles, however, is not in a vacuum. Over the past two decades areas where jobs are plentiful also have gained a reputation for above-average housing costs be it to own or to rent. As a result, a lot of Americans find themselves in a situation where buying an all-cash home purchase simply isn’t realistic. In many locals, even rent on a median average income is a stretch!
Ramsey typically falls back on a very ubiquitous assumption: that apartments are significantly more affordable. But apartment living can become a trap for many, even those with the benefit of two incomes. In part, that is because rents in job-plentiful areas tend to increase year-to-year even if wages and salaries remain flat. Over time, one’s cost to be a long-term renter over that of a homeowner who locked in a mortgage payment 15-20 years earlier will begin to level out (or even reverse).
In some parts of the country, as a result of rental inflation, it’s actually cheaper to own than to rent assuming the ability of a buyer to put down a reasonable down payment. Unfortunately, Ramsey’s advice rarely if ever makes key geographic distinctions. Moreover, Ramsey’s advice tends to assume that if you can’t afford housing, you can simply move to a more affordable area. But moving any significant distance to obtain lower cost housing is not to be taken lightly, either. Moving to a new area requires a job and housing lined up in advance, otherwise it can be a recipe for disaster. Because many people are paying so much of their incomes toward housing, they can scarcely raise the funds, even, for a cross-country move — say from the pricey Bay Area in California to a more affordable Midwest city. In this way it is possible to become “trapped in place” — another phenomena that disproportionately impacts those who can least afford to live where they do.
In summary, Ramsey’s advice seems geared for higher-than-average income earners who are already in a position to have an idea what they can and cannot afford. His advice doesn’t square as successfully with average or mid income-earners, who must find a way to put a roof over their heads whether they can comfortably afford it — or not.