- Before you buy, make sure you could handle being house-rich, cash-poor...
A lender will tell you that you’re approved for a certain number when you initially apply for a mortgage. But it’s important to know that their pre-approval number simply represents the maximum they’re willing to lend you based on your income, credit, debt, etc. It doesn’t necessarily represent what you can comfortably afford to pay every month without feeling financially squeezed in other areas.
Figuring out what you can realistically afford requires more honesty and math than most people bring to the process. Let’s explore a better way to approach it.
The Standard Guidelines
The most commonly cited rule in mortgage lending is the 28/36 rule. It says your monthly housing costs should not exceed 28 percent of your gross monthly income, and your total debt payments (including housing) should not exceed 36 percent. On a gross income of $6,000 per month, that means housing costs of no more than $1,680 and total debt payments of no more than $2,160.
These numbers are useful as a starting point, but they have a pretty big blind spot. They’re based on gross income, not net. And as you know, you don’t live on gross income. You live on what hits your bank account after taxes, retirement contributions, health insurance premiums, etc.
Knowing all of this, be sure to run the numbers using your actual take-home pay, not your salary. That gives you a more realistic picture of what a monthly payment feels like in practice.
What “Housing Costs” Actually Includes
When it comes to home loans, people don’t always factor in all of the costs. The mortgage principal and interest is the number most people focus on. But your actual monthly housing cost includes several other items that add up fast.
There are property taxes, for example, which vary significantly by location. In some states, annual property taxes on a $350,000 home are maybe half a percent (e.g. $1,700). In others, they can be double or triple that. That difference alone can add hundreds of dollars per month to your payment.
Homeowner’s insurance is required by every mortgage lender and costs vary based on location, home value, and coverage levels. Private mortgage insurance, or PMI, applies if your down payment is less than 20 percent and adds another layer of costs.
If the home is part of a homeowner’s association, monthly or annual HOA fees apply. These could be anything from just $10 a month to keep the street lights on all the way up to several hundred dollars per month to fund common areas, pools, street paving, and other neighborhood-funded amenities.
And then there are the costs of actually owning and maintaining a home. A common estimate is that annual maintenance and repair costs run between one and two percent of the home’s value per year. On a $350,000 home, that’s $3,500 to $7,000 annually that you need to be prepared for.
Use a Calculator to Run Real Scenarios
One of the most practical things you can do early in the homebuying process is sit down in front of a home affordability calculator and run different scenarios. Play around with all of the variables:
- Income
- Down payment
- Interest rate
- Property taxes
- Loan terms
- Existing debt
- Etc.
See how each factor change affects what you can afford and what the monthly payment looks like.
Home Connect has a solid affordability calculator on their website. If you scroll to the bottom of their home page, the tool lets you input your income, estimated taxes, existing debt, down payment amount, expected interest rate, and preferred loan terms. Playing around with those inputs gives you a clear picture of your affordability range rather than relying on rough estimates or generic rules.
Spending 20 minutes with a tool like this before you start shopping saves you from falling in love with houses that are outside your comfortable range. It also gives you a concrete number to share with your real estate agent so they’re showing you properties that fit your actual budget.
Buy Below Your Maximum
The single best piece of homebuying advice is to spend less than what you qualify for. Lenders will approve you for the maximum amount their guidelines allow. That maximum does not account for everything else you have going on in your life. While you might be approved for a $750,000 loan, it may make more sense to only plan on taking out a loan up to $600,000. This extra margin could be enough to help you fund a 529 for your child’s college education or build up some savings for travel. Whatever the case may be, it gives you breathing room, which is a win.
Adding it All Up
A house that comfortably fits your actual budget is a better purchase than a house that stretches you to the edge. No matter what anyone else tells you, financial security as a homeowner feels way better than a bigger living room in the long run. Figure out what you can afford, stick to that budget, and enjoy your life!