The other day my wife and I were dreaming about our future home. Since we are planning on buying our first home in a couple years, we are already making the plans. It’s never too early to start saving the down payment. The conversation drifted towards what kind of house we will look to buy.
We talked about our current 1 bedroom apartment and all of the the feature that we like about it. We also expressed our dissatisfaction. All of the things that we want to be upgraded in our new home. Even though we are years away, our fun little conversation sprang into planning our future home. Two-three bedrooms. A modest back yard. The list goes on and on.
Unfortunately, this is how I imagine most first time home buyers start planning for their first home. They get caught up in the dream and fail to think about how much house they can afford. Or, the popular way of thinking about how much house you can “afford” is instead a checklist of items that you “need.” In all actuality, these things are simply wants. It has nothing to your budget nor your financial goals.
Popular Ways to Determine How Much House You Can Afford
As it turns out, after a little bit of research there are a lot of generalizations out there about how much house you can afford. Everyone has their own advice on what you should be able to afford, based on different figures. Here’s some of their advice
- 28-40% of Monthly Income - One rule of thumb is that you can afford 28-40% of your monthly income for your housing costs. This means that if you are earning $10,000 you can afford to pay somewhere between $2,800 and $4,000 each month on your house.
- 1.5-3x Your Annual Salary - Another popular number that is thrown around is 1.5x-3x your annual salary. If you are earning $100,000 each year, that means you can afford $150,00-$350,000 in a house.
These are just some of generalizations that help you determine how much home you can afford and they should be treated as such. While they may be helpful, they fail to take into consideration the true costs of owning a home and your current budget. You cannot rely on these estimates if you are looking to buy a home. Doing so may lead you to foreclosure or something even worse.
Expenses with Buying a Home
In order to better assess whether you will be able to afford a house, or how much of a house you can afford, you first need to understand the number of expenses that buying a home entails. It’s not the same as renting. You don’t just have a monthly payment anymore like you would if you were renting.
- Down Payment - One of the first costs that you will incur when buying a home is the down payment. Usually lenders will require 20% of the home value as a down payment. While it is possible to buy a home with less down, usually this comes with additional costs.
- Closing Costs - These are often the fees that are overlooked when buying a home, so first time home buyer is usually forced to empty any and all emergency funds at the last minute. These fees will include (but are not limited to): escrow fees, legal fees, inspections, prepaid loan interest, and more.
- Homeowners Insurance - Homeowners insurance is usually an additional few hundred (or maybe thousand) dollars each year, depending on the value of the home and locaiton. Usually this is a requirement to get the final approval for the mortgage from the lender.
- Taxes - One of the additional costs that homeowners occur is property taxes. These will vary depending on the property value and the location of the property, you must account for these additional costs.
- Maintenance - Maintenance may be difficult to predict, but some say that you should budget for 1%-3% of the property value for maintenance. Some years will be less and some more. Regardless of the amount, you can bet on one thing: repairs are necessary.
- Monthly Mortgage Payment - Last but certainly not least, is your monthly mortgage payment. This will depend on the amount of the loan, the interest rate, and the duration. While you may initially aim to match the amount you are paying in rent, considering all of your other costs, you should probably look to have a lower mortgage payment than your rent.
Other Factors that Affect Your First Home Budget
Estimate how much house you can afford isn’t simply adding up all the costs and seeing if you have that much in your monthly cash flow. There are many other important things to consider.
- Retirement Planning - Do you have big retirement goals? Are you trying to max out your Roth IRA each year or maximize your 403(b) contributions? Buying too big of a house may put these goals on hold for years, if not decades. Make sure to consider your retirement planning and don’t assume that buying a home is ultimately the best thing for your retirement goals.
- Other Debts - People who have lots of consumer debt should not be thinking about buying a home. Before you even think about buying a home, figure out how much debt you have and what you can do to lower your debt. Not only will this lower the risk involved in buying a home, but this will increase your monthly cash flow thereby allowing you to pay for all of the expenses mentioned above.
- Children - I can’t stress the importance of this enough! If you are thinking about having children soon, you need to take that into consideration. Will it prevent one of you from working? If so, make sure that either you save up enough money to afford it or buy a significantly smaller home.
Estimating How Much Home I Can Afford
Like I already mentioned, my wife and I are a couple years from being able to afford our very own home. We aren’t planning on having kids anytime soon, but we do have aggressive retirement savings goals. Not only are we maxing out our Roth IRA’s, but we are also contributing to our 403(b)’s in addition to some other investment opportunities. This is really important to us. As much as we want to buy a home, we don’t want to dig into our retirement savings in order to buy our own home. That would delay our retirement several years.
When we buy our first home (or condo), we are going to make sure that we don’t overspend. We are currently estimating somewhere between two and three times our household income. When we buy, we will put 20% down. This will put our monthly payment, including taxes just a little higher than what we are currently paying. We are fine with that since we are currently saving more than enough each month AND we would be building up equity in an asset.
Readers, how did you figure out how much house you can afford?