How much house can you afford?
Updated: Aug 16
You may be dreaming of buying a house but be unsure about how much you can afford to pay.
Many financial institutions, realtors or mortgage brokers will lead you to believe that you can afford a house payment that may be as high as 40% of your take home pay on a 30 year note with little or no down payment. Actual numbers will vary quite a bit based on tax rate, interest rate and insurance costs. A very rough estimate based is that someone making $6k/month could buy a house worth around $400k or more with no cash up front. The truth is you can do this; but it doesn't mean that you should. People that buy the most house they can “afford” according to loan qualification standards are likely to find themselves house poor, or worse – in foreclosure some day.
Here are some guidelines to consider that differ from the scenario above.
1. House payment (including taxes and insurance) should not exceed 25% of your monthly income. This guideline can be used when selecting a place to rent as well. Going over the 25% rule of thumb is certainly possible. However doing so is likely to leave you struggling with other large goals like buying a car, or saving for retirement.
2. Put down at least 20% on a conventional loan. If you can buy the house cash, even better. There are many home loan programs that will allow less than 20% down. There is nothing wrong with these programs, they just may not be in your best long term financial interest. When you purchase a home with less than 20% down, you will likely be required to pay for PMI insurance. This insurance covers the lender's losses in the event that you default on the loan. Costs vary of course, but PMI for the $400k house above might run in the $250-$300/month range. That's a lot for insurance to cover someone else's risk. Under some loans, you will be able to stop PMI payments once the loan balance becomes less than 80% of the value of the home. Some loans require you to pay PMI for a number of years regardless of your balance. If you don't put down 20%, make sure you understand your PMI requirements.
3. Finance for a 15 year timeframe (not 30). There are two reasons for this guideline. The simplest is the cost of interest. Even at a low rate (e.g. 3.25%) the interest on a home can be significant. The $400k home mentioned earlier would accrue $226k in interest over 30 years. Over a 15 year note, the interest would be $105k. That's a difference of $121k on a $400k purchase. The second reason is setting yourself up to be debt free. It is very advantageous to be debt free by the time you retire. Even if you are younger than 35 and not worried about retirement yet, think about what you could do with no house payment.
These suggestions mean that someone bringing home $6k/month would be better served looking for a home closer to $250k purchase price with a down payment of 20%. (Please note: the math in this document was based on 3-4% interest rates. Taxes, insurance and interest rates vary greatly, so do your math or have your realtor walk you through it).
Home ownership can be a great blessing.
If you buy a home that is too expensive or without considering the additional costs you can find yourself house poor for quite some time.