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How much house can I afford?

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Home for SaleI still remember when I bought our first house, which we still live in today, and if you read the blog back in 2005, you probably remember when I bought our first house too. (the wonders of blogging!) It was the biggest financial decision of my life up to that point, whether to sign my name to buy a house nearly five times my salary. We purchased the house for $295,000 and my salary that year was something like $65,000 (math geniuses will surely note that it’s closer to 4.5 times). I still remember going to the bank and getting the certified check and how I’d never seen a check with a number that big before and how crazy it was to spend that much money at one time.

I think it’s a rite of passage. While I don’t consider it the point at which I “grew up,” I certainly grew up a lot after ponying up that much cash for one single thing. Here’s the crazy part… the check wasn’t the part I should’ve focused on. It was the thirty years of payments I was agreeing to pay. Three hundred and sixty payments. I hadn’t even been alive that long.

Looking back, I think we made a good decision (despite home prices) but knowing how much house you can afford is an important step in any home buying process. Here’s how you determine how much you can afford.

Debt to Income Ratio

Behind most “how much house can I afford?” calculators is a basic premise – lenders will only lend you a dollar amount up to a certain “debt to income” ratio based on the monthly mortgage payment. If your after-tax income is $3,000 a month and your mortgage is $1,500 a month, your debt to income ratio is 50%. Calculators then use a conservative ratio, something like 20%, and an aggressive ratio, closer to 33%, and then use that to calculate your monthly mortgage payment. They use that to figure out how large of a mortgage you’d qualify for, given current rates, and that’s how they calculator “how much house you can afford.”

There are several problems with that approach and this illustrates the flaws in this approach, which is often fixed with more complicated calculators (that are less fun to use). Simpler calculators don’t factor in all the other financial obligations you have – such as other debts (student loans!), fixed expenses, and payments you need to make that. While not technically “debt,” they sit on your personal balance sheet like an accounts payable every month. The calculators that do include those amounts can give you a better picture of how much house you can afford because they include those extra payments.

How Much House Can I Afford vs. How Much House Should I Buy?

The real question, however, isn’t how much house can you afford, it’s really how much house should you buy. Anything solved by a simple calculator likely isn’t the important question you should be asking yourself. Calculators just get you the numbers faster than doing it by hand but they do little else.

The first question you need to ask yourself is – what kind of house is this? Is this a house I will raise a family in? Is this a starter house where I will spend the next 5-8 years? If you are buying a house for the next 20-30 years, it needs to be big enough to accommodate your family. If you plan on having four kids, you need a larger house than if you plan on have no kids. This has absolutely nothing to do with your debt to income ratio and no calculator and tell you how many kids you want.

When thinking about how much house we wanted, we knew our current home was going to be a “starter” one in which we wouldn’t be in for twenty or thirty years. The next one will be. If we plan on two kids, then we will want at least four bedrooms. One for each kid, our own, plus a home office. If we want three kids, up the bedrooms to five. From there, we add all the other characteristics we want in a home (fireplace would be nice, a yard would be nice, etc) and then we start using the calculators to find out how much house we want to buy.

Rent to Income Ratio

Debt to income is a good ratio but I believe a more accurate one is rent to income ratio. Talk to any landlord and they will not rent to you if the rent to income is greater than 33%. That is to say, they do not want you spending more than a third of your income on rent. I think you should take that rule and apply it to your housing payment, whether it’s rent or a mortgage, and not buy a home in which your monthly payment is greater than 33% of your income. In fact, many experts say that you should avoid anything over 25%.

Remember, your monthly payment for housing will include the mortgage as well as property taxes, utilities, HOA (if applicable) and other costs associated with owning a home. Stick to 25% and under to be safe, 33% at a maximum.

We’ll be looking for a new home in the coming months, scouring Redfin as we always have, and using these metrics to see whether a house (after we find out if it’s aesthetically appealing) fits our budget.

(Photo: PurpleHousePhotos)

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8 Responses to “How much house can I afford?”

  1. Vincent says:

    Are you sure that debt to income ratio uses take-home pay (instead of gross pay?)

    http://en.wikipedia.org/wiki/Debt-to-income_ratio

  2. Adam says:

    Great post. I think buying too much house, and not anticipating how much your 20% down payment is, will have incredible financial impacts down the road. being smart with likely the biggest purchase of your life will save you from financial heartache down the road.

  3. Bryan says:

    When I bought my house, people were telling us we qualified to get a bigger loan, and therefore a bigger house. We saved 20% to put down, and that brought the house (with property taxes) down to around the cost of what we were paying for rent.

    We didn’t get a house as an alternate 401k investment, we got it to have space, and not hear neighbors through the walls. When the banks told us what we qualified for, I just laughed and told them I would have to be a total moron to take out a loan that size.

    The bonus of buying what we needed rather than a McMansion, is that we have a lot of left over money that we use to take nice vacations with.

    If we do decide to sell, it’s still in a nice area, and we should be able to break even on it (we did some upgrades that cost a bit of money)

  4. huskervolleyball1 says:

    My daughter is buying a short sale in the Washington metro area. The owner paid $250,000 four years ago. The bank is considering her offer of $110,000.

    I told the real estate agent I was amazed at this turn of events. (Nebraska did not have the housing downturn, we are rated #1 economically in the past crisis.) The agent told me of an open house she had in 2009. The home was $550,000. A lady fell in love with it. Agent had lady call mortgage banker. He told her that she would be approved for a loan on the house. Her salary was $25,000.00 per year. Is it any wonder that things went so bad??? Greed took the place of common sense.

  5. Demi says:

    I have seen a lot of deals come apart once the potential buyers ask the question: what are the reoccurring non-adjustable monthly costs? Taxes. Fixed minimum water and sewer costs. Trash/recycling. HOA costs. Minimum home owners liability insurance. All required costs to live in my home and costs you can not escape nor does the home owner have any control over. You can use less electric. And you can forgo TV cable and home phone services. But the bare minimum costs are on top of the monthly mortgage. Those minimum required costs are $600+ a month more for me on top of any mortgage. And I know that is cheap compared to some areas. So a $1,200 a month mortgage easily becomes $1,800, or more, a month with the addition of local services you can not escape. This has killed many a deals in my neighborhood and many of those potential buyers commented that planning on 4-6% increase per yer in those fixed costs, in 10-15 years, would double that fixed cost. Since most of America’s workers have not been seeing a yearly raise in their compensation, buyers really have to look to their future before they make a 30 year commitment. This last crash cost us all even though many of us have used good prudence regarding our financial liabilities all along. It ticks me off thinking of all the “things” I could have yet I did not take the leap because I didn’t want to leave my backside hanging out. And here what are we doing anyway…cleaning up someone else’s mess. Oh well. I guess that’s life.

  6. Shirley says:

    We bought a house when I was 22 years old and we had two very young children. We very carefully considered the extra amount we would be paying for ownership and decided that three bedrooms and two bathrooms was worth the extra frugality. There were a few times when unexpected maintenance set us back to paycheck-to-paycheck living but we made it.

    We raised five children (and some of their friends, I think) in this house, but never more than two at a time, so our goal of each having their own space worked out fine. There were times when I would have liked to have had a bigger house but we stayed with what we knew for sure we could afford.

    Now 49 years later we are both retired with one young adult left at home, no debt whatsoever, and plenty of room. Staying within our financial comfort zone worked out beautifully.

  7. We bought our first house last year for $109,000. The banker told me we’d qualify for 2-3 times that much, but honestly, I’d rather be debt free in 10 years than the traditional 30.

  8. Money says:

    There are 2 simple formulas for buying a house.

    One is price per square feet and the other is profit/house price aka return on asset


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