How much can I afford for a house ? That’s a question I hear often. Last week I answered the question, “Is now the best time to buy a house?” OK…some of you agreed with me and some didn’t. For those of you who refuse to keep your powder dry and want to buy now, the question becomes how much house should you buy? Here’s a checklist to help you decide:
1. Under My Thumb
A rule of thumb I use is to buy a home that costs no more than four times your annual household income minus all other debt payments.
So, if you have no debt and earn $75,000 a year, you should buy a home that costs no more than $295,000. But let’s say you have car payments, student loans and credit card payments all totaling $35,000 a year. In that case, the maximum you should spend on a home would be $160,000 ($75,000 minus $35,000 times four).
This is a rule of thumb and you have to treat it as such. If you have a high enough credit score, if you are sure your income is going to rise or if you are about to inherit a pile of cash, you might tweak these numbers.
2. Down Payment
Your down payment is simple. How much money do you have to put down? Divide that number by 20%. That’s the maximum loan you’re probably going to get because banks want you to have at least that much skin in the game.
Of course, that doesn’t mean you’ll qualify for a loan of that size or that you can afford the payments or should take the loan even if you can afford it. But I digress.
Let’s assume you have $50,000 to put down. The highest purchase you can qualify for will be $250,000. You’ll put down 20% ($50,000) and the bank will loan you $225,000. (Read “How You Can Qualify For A Loan.”)
You can get a rough idea about your payments by using a mortgage calculator. It uses current interest rates and amortization schedules. You can also see what the payments will be based on a 15-year or 30-year mortgage. This is the easy part.
(Remember, you’ll get a tax deduction for the interest you pay on your mortgage. That will make your house payment a lot more affordable. For example, if you are in the 35% marginal tax bracket and you pay $20,000 a year in interest for your home, you’ll write that $20,000 off and it will save you $7,000 a year.)
4. Closing Costs
Banks love to “sock it to you.” But you can reduce closing costs without too much trouble. The bank has to give you a good faith estimate of these costs before you fund the loan. Don’t wait. Mortgage brokers are still hungry to get your business. Tell them to give you an estimate of the closing costs even before you identify the home you want to buy. This is a one-page document. Make sure you understand every single item they are charging you for. Just by going over it, you’ll intimidate the bank into reducing those fees.
When you buy a home, you might do some landscaping and other remodeling. How much do you have in reserve to do that work? If you don’t have much, don’t buy a home that will require it.
When you move, you’ll likely have to upgrade from bean bag furniture to something normal people actually use. I’ll never forget visiting a friend of mine who bought a beautiful 5,000-square-foot home. He bought so much over his head that he wasn’t able to furnish it. Five years after the purchase, he’s still using bean bags – I’m not making this up.
Don’t let this happen to you. Put some money aside for furniture.
7. Property Tax, Insurance and Upkeep
Renters have the luxury of knowing exactly what their living expenses are going to be – at least for the length of their lease. Homeowners don’t. You can easily determine what your property tax and insurance is – and don’t forget to do so. (Read “How to Reduce Property Tax.”)
But also consider upkeep. It all adds up. I budget two months’ mortgage payments every year for unforeseen repairs and I try to estimate all the recurring expenses like utilities, gardening, etc. I keep track of these expenses too.
Owning a home ain’t cheap. I still think it’s a fantastic investment and much better than renting (I’ll explain why in another post).
It’s just that if you go ahead and buy property, I want you to be able to hold on to it. The best way to do that is to buy a property you can afford from the start.