Regardless of whether you rent or buy, housing is likely to be one of the largest expenditures you will have over your lifetime, second maybe only to taxes. Obviously, paying your tax bill feels a whole lot worse than paying your mortgage, which is why we all do our darnedest to minimize our tax liability. Still, making the right housing decisions can have just as much of an impact on your finances, and as a result, other areas in your life too.
Should You Be Buying A House?
Before we get into how much house to buy, I’d be remiss if I did not mention that buying a house might not be the right decision for you in the first place, depending on your situation. There are a few major factors that go into the decision for whether to rent or buy:
- How long do you plan to live in the house you would be buying?
- How much do you have saved – both for a down payment and for potentially unforeseen expenses after purchase?
- What do homes typically cost in your area?
- What interest rates and types of loans can you qualify for?
The New York Times has a great rent vs. buy calculator to determine which option will cost you less, from a financial standpoint: https://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
Now, if you’ve passed that sniff test and are still in the market for your dream home, let’s move on to discuss how much to spend.
What A Lender Will Say You Can Afford
If you’re like most people, you’ve started the home buying process by going to a mortgage lender and asking, “How much money can I qualify for?” The lender asks for a little bit more information about your financial assets, income, debts, etc., etc. Then the lender does their little “magical” calculation and spits out a number. Chances are, it’s much higher than you expected – which is great, right?! Not exactly…
What they’ve done is given you the maximum amount you could possibly afford, using the information you gave them. According to Fannie Mae qualification guidelines, that maximum number is currently at a 45% debt to income ratio (but can vary by lender anywhere in the 40-55% range). That means 45% of your pre-tax income would go to repaying your mortgage debt. Taxes and other fixed expenses (like gas, internet, electricity, insurance, etc.) would need to be paid from what’s left, eating up even more of your income! That doesn’t leave room for much else at all, including saving toward your future plans.
Far too many people take what the lender says they can afford for granted. They never take a step back to run the numbers on their own and think about how much that maximum monthly mortgage payment will impact their lives. Don’t let that be you!
What You Should Actually Pay…
The commonly held rule of thumb is to make sure your housing costs are no more than 28% of your pre-tax income. “Housing costs” is pretty vague, though, so let’s define what that includes:
- Your mortgage (principle and interest),
- Property tax,
- Insurance
This is a combination otherwise known as PITI (principal, interest, taxes, and insurance), and every financed home purchase is going to have these costs – what a PITI! (OK, I’ll show myself out…) There could be additional costs that you may need to factor in, depending on your situation. They are:
- Private Mortgage Insurance (usually required if you put less than 20% down – more on that later), and
- Home Owner’s Association dues
It’s the sum of all of those costs together that you will want to keep under 28% of your gross income, even if a lender is willing to give you more.
Moving from monthly costs to a total purchase price
A back of the napkin way to calculate the most you should pay for a home is by taking your salary and multiplying it by 3.8 (using March 2018 interest rates for borrowers with good credit). As interest rates change, that multiplier will change as well. If you think about it, this makes sense. You can afford less house when you’re paying a higher price for the mortgage (which is really what mortgage interest is anyway).
Likewise, you may need to adjust the multiplier slightly depending on where you live. For example, in higher priced areas like CA or NY, you will likely need to stretch a little further (4.5-5x your salary) to even find a place to purchase. Having to stretch on housing means you will need to save more for a downpayment or be prepared to make tradeoffs in other areas of your budget to cover the larger mortgage expense.
If you want a more exact purchase price to aim for that fits you and your situation, you can use this calculator we built:
Calculate a target purchase price for your budget
How Much of a Down Payment Should You Make?
From a purely mathematical perspective, the answer is as little as possible so the monthly payments are within your budget and you aren’t forced to pay any unnecessary costs, like PMI (Private Mortgage Insurance) for conventional lenders or MIP (Mortgage Insurance Premiums) for government-backed lenders. After all, leverage is one of the key factors in real estate being such a good deal.
For most loans, you will need a downpayment of 20% of the purchase price to avoid the added mortgage insurance costs, so so you might as well aim to have 20% saved for a downpayment. (Though, I have seen some lenders recently that offer PMI free mortgages with as little as 10% down for qualified, high-income borrowers.) I always recommend having the downpayment saved in addition to your emergency fund. There will be unexpected expenses, and you want to make sure you still have some reserves to cover them when they pop up.
Keep in mind, there’s no rule that says you can only put 20%. You can always put more down if your situation calls for it and it makes you feel more comfortable. Doing so will lower your monthly payments and free up more cash flow for other things that are important to you, which can provide peace of mind.
Consider Doing a Trial Run Before You Buy
Buying a home is a serious commitment – one that you will likely need to live with (though not necessarily in) for at least five or so years in order for it to make financial sense. A lot can happen in five years. Before you take the plunge, it can be a good idea to test the waters by acting as if you’re already paying your new projected monthly housing costs.
If you’ve gone through the calculations above, you should have an estimate of what your total new housing costs will be. Assuming it’s higher than what you’re currently paying for housing, try putting the difference between that new amount and what you’re currently spending on housing into a savings account every month and see how it affects your cash flow.
If your budget isn’t constrained after a few months and you’re still able to do everything you want to, awesome! Things are looking good for your ability to handle the costs of homeownership. However, if you aren’t able to put that amount away or you’re having to make sacrifices in other areas, then you will want to look at reducing the purchase price until it feels more comfortable for you.
Other Things To Think About
What type of mortgage should you get?
There are two broad categories of mortgages to choose from: fixed-rate mortgages and adjustable-rate mortgages (ARM). Within those categories, there can also be different types.
Fixed rate mortgages offer an unchanging rate for the length of the loan, which is typically either 15 years or 30 years. Rates for the 15-year loans tend to be a little bit lower because they’re less risky for the lender. However, because you’re paying off the same principal balance over half the time, the payment is going to be much larger for you than the 30-year loan.
Adjustable rate mortgages, on the other hand, have a fixed rate for a certain period of time, but after that initial period, rates can fluctuate. either up or down, depending on what market interest rates are doing at the time. For example, you could have a 5-year ARM. During the first 5 years, the rate doesn’t change, but after that, it might be higher or lower than your initial rate. You won’t really know for sure until that time comes.
In general, I prefer fixed-rate mortgages, regardless of whether they are of the 15-year or 30-year variety. That being said, there are instances where an adjustable mortgage can make sense. For instance, you might want to review an ARM if you expect interest rates to drop by the time the adjustable rate kicks in or if you’re able to get a lower interest rate than you could with a fixed and don’t plan to still have the mortgage in place when your rates are adjusted. More often than not, though, a fixed-rate mortgage is the way to go.
If Your Income is Going to Change (Or One Spouse is Going to Become a Stay-at-Home Parent)
It’s not uncommon for me to see couples who want to buy a home and then start a family soon after. Usually, at the stage where they are looking at buying a house, they are both working and receiving an income. But that doesn’t mean they both want to be, or plan to continue. If one is going to stay at home with the newborn, or if you know your income is likely to drop soon for another reason, take that into consideration before you buy a house you cannot afford.
In situations like this, plan to use only the lower income number when running your calculations of how much you can afford. (Again, don’t just go off of what a lender says you can afford based on your higher, dual-income numbers.)
On Stretching Yourself for Your First House
I’m sure you’ve heard people say you should stretch yourself a little bit, especially if it’s your first home. I’ve heard of comments like:
“You’ll want more space in a good neighborhood for the kids, even if you have to buy a little out of your budget. Besides, you’ll get raises at work, which will reduce the monthly burden, at which point more can go to savings.”
or
“The housing markets just keep going up, and this is in a great part of town. You can always sell later, and you’ll definitely make money then.”
The problem with that way of thinking is that life doesn’t always happen as expected, yet you are depending on an unknown future for this decision to make financial sense. What if that raise doesn’t come? Or housing prices don’t increase at the rate you planned them to? Or what if you need to replace the water heater and you used all of your savings for a down payment? Though, I hear cold showers are good for you!
To double down on the issue, you’ve also potentially closed yourself off from other possibilities in making progress toward your dream life if there’s no wiggle room in your budget. Doing so can be a disservice to your current self as well as your future self.
In summary, I’m not saying that it’s never a good idea to stretch a little bit, but you do need to assess your situation carefully, know where you are willing to make tradeoffs, and know what the ramifications of those tradeoffs could be.
Why Buying a House Can Be One of the Best Decisions You Make
Once it makes sense from a cash flow perspective, there are many tangible and psychological benefits to purchasing a home.
As mentioned previously, leverage in the form of a mortgage can be a terrific way to increase the return on your purchase (even though you should not look at buying a home as an investment) and your total net worth. To illustrate the power of leverage, let’s say you are going to purchase a $500k home and housing prices increase by 4% annually in your area. You are also going to put $100k down and take out a mortgage for $400k, also at 4% interest. At the end of the year, your house increases by $20k in value while paying about $15k in mortgage interest during that first year, which is about a 5% return on the $100k you put down. That doesn’t look like such a great deal at first glance. But of course, that’s not the whole story, because you get to deduct that mortgage interest on your tax return, which leads us to the…
Potential tax benefits of owning a home (which won’t be as great for some people under the 2018 Tax Cuts and Jobs Act). As mentioned in the example above, you are able to write off the interest on loans that are used to acquire or improve your house, as long as the loan amount is less than $750k for new home purchases in or after 2018. Since you will be able to deduct the interest on the entire mortgage above, your actual return on the $100k will be about 8.75% after the tax benefits, assuming you’re paying at a 25% tax rate. As your tax rate goes up, so does the benefit received by the mortgage interest deduction.
You are also able to write off property taxes to the extent that your total state and local tax liability is less than or equal to the $10k cap under the new tax code. This will benefit you more if you live in a state that has low income or sales tax rates and less so if you live in high-income tax states.
You actually get to enjoy your home. Unless you’re Scrooge McDuck, you don’t get to enjoy your investments to the same extent you will enjoy your house.
You can’t sip a cup of coffee on the porch of your brokerage account or throw the ball around with your son in the backyard of your 401k. But those are all things you could get to do (along with whatever it is that you really want to do) when you purchase a house and turn it into your home.