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How Much House You Can Afford?

More than one reader has emailed me in the last month asking how much house I thought they could afford in our sinking housing market. One reader, Chester (not his real name), lived in California where home prices still seemed like they were in the stratosphere despite lowered prices, and the other (Wilson, also not his real name) lives in the Washington D.C. region where demand has kept home prices relatively stable. In both cases, I think the question of “how much house can you afford” is independent of the local real estate market and more a product of their spending habits and local cost of living.

25% – 33% Rule of Thumb

Conventional wisdom says that you shouldn’t spend more than a quarter to a third of your before-tax salary on housing. If your annual salary is $50,000, then you’ll want to have a monthly payment between $1,042 and $1,375. Remember to subtract real estate taxes, HOA fees, condo fees, homeowners insurance, and other recurring monthly costs from those numbers to calculate how much home you can afford. $1,042 – $1,375 is the range for your total monthly payment, based on the rule of thumb.

How do you work backwards? There may be a better way but the easiest is to play around with some numbers in DinkyTown.net’s Mortgage Loan Calculator (PITI) [3]. Playing with the numbers, I found a monthly payment of $1,286.08 given these assumptions:

If you assume 20% down ($37,500), that’s a $187,500 home.

Adjusting the Rule

The rule is good as a starting point but you may have circumstances that can work for or against you in terms of how much you can pay each month. Existing debt is one scenario that could reduce the amount you should spend on housing because every month a set amount is earmarked towards retiring that debt. If you live in a high cost of living area and your budget says you can’t afford to spend 25%-33% of your salary on housing, you’ll have to adjust it (the opposite may also hold true).

Chester in California has student loan payments of about $300 a month that he’ll have for the next twenty years, locked in at a favorable sub-4% rate. It’s not something he’s looking to pay off quickly so it will be with him for a while. He also has a car payment of a few hundred dollars (I’m assuming the magnitude, he just said he had a car payment) a month so he already has a percentage of his take home page ear-marked towards servicing existing debt. This could adjust his housing allocation down more towards 25%, rather than 33%.

Analyze your budget and see if you have room to adjust your ranges higher too. You might find that you’re saving 50% of your salary because you live lean or in a place with a low cost of living. You might be willing to adjust that number higher to own a little more house. By having a budget, you can make these decisions with concrete data rather than with gut feeling.

The only warning I’d offer is that it’s far easier to get into debt than it is to get out of debt (duh). A mortgage stays with you a very long time, so don’t rush into getting a larger one than you think you can afford comfortably.

Finally, remember that the recent housing rescue bill [4] included a provision about the $7500 first time homebuyer tax credit/loan [5] that you may be eligible for.

(Photo: orvaratli [6])