In an April post, we reviewed instances where paying off a mortgage might be beneficial. But first-time homeowners and prospective buyers – especially given the booming housing market – are likely asking themselves how much house can I afford in the first place? This post will give tips on determining how much mortgage you can afford. Housing will most likely be the largest expense in your budget, so it’s never been more important to make sure you don’t overspend on a new home.
The current state of the housing market
It’s no secret the housing market is red-hot. But why? It’s a classic case of supply and demand: there are more prospective buyers than there are homes for sale. All things being equal, when demand is greater than supply, prices increase. This is regularly illustrated with other goods and services, such as gasoline, designer clothes, or, in true 2020 fashion, hand sanitizer.
In fact, Redfin’s annual report on the housing market highlighted that active listings (i.e. homes for sale) are down 42% year-over-year as of March 2021, and a staggering 39% of homes sell above their listing price. What’s more, the National Association of Realtors reports that the average listing is only on the market for 18 days. Taylor Borden of Business Insider states that “America is running out of houses,” implying that the shrinking supply makes it more costly – and challenging – for buyers to purchase a home in this market.
Buying a home is an inherently emotional process – it’s where you and your family will spend years (if not decades) building a life, so it’s easy to get caught in a whirlwind of emotion. But keep in mind, buying a home is also likely going to be the largest financial transaction of your life. So how can you take emotion out of the process, or at least mute it’s impact? How do you know how much house you can afford? We’ll review a few rules that can help you determine just that.
The 28% Rule
The general rule of thumb is that your mortgage payment should be no more than 28% of your monthly income. Two ways to look at “monthly income” are gross versus net.
Gross income is your salary or wages before taxes and benefits (such as health insurance and 401(k) contributions) are deducted from your pay.
Net income, therefore, is the dollar amount actually deposited in your bank account each paycheck (i.e. your income after taxes and deductions). In other words, gross income is how you look on paper, but net income is how you put food on the table and pay the bills.
It’s important to note that banks often calculate your maximum loan amount using gross income.
Considering, however, that your mortgage payment will likely be the largest expense in your budget, it may be more prudent to calculate your maximum mortgage payment based on how much cash you’ll actually have at your disposal. In other words, consider using your net income to figure the 28% rule maximum.
As a side note, using the net income approach may also be easier for “mental accounting” purposes: most people you are more likely know your net paycheck amount off the top of the head than you are the gross amount before taxes and deductions.
Let’s assume that your salary – i.e. gross income – is $90,000 per year ($7,500 per month). However, this does not account for the taxes, 401(k) contributions, and health insurance deducted from your pay. So, let’s further assume those three deductions add up to $1,500 per month – leaving you with a net income of $6,000.
Based off your gross income, a mortgage lender might be willing to extend a loan that costs you up to $2,100 per month ($7,500 x 28%).
However, when calculating payments using net income instead, your maximum mortgage payment should be $1,680 ($6,000 x 28%), a difference of $420 each month. There’s a lot you can do with an extra $420 – put it in a Roth IRA, pay off higher interest rate debt, or save for a child’s college, for example. It could also be used as a buffer in your budget to cover potential unexpected expenses.
The lesson here: mortgage companies make money by charging interest on loans, so they are incentivized to encourage individuals to take out larger loans. For this reason it would be wise to calculate on your own how much house you can afford rather than blindly going along with what the bank tells you.
The 36% Rule
While the 28% rule only accounts for your mortgage payment when considering how much mortgage you can afford, the 36% rule includes all your outstanding debts (i.e., car loan, student loans, or a credit card balance). Under the 36% rule, your total debt expenditures should not account for more than 36% of your net income.
Why 36%? Banks are generally wary of extending loans to those with a debt-to-income ratio of more than 43%. With a ratio that high, all it would take is one unexpected bill or financial emergency to upend your financial situation and jeopardize your ability to repay the loan. Banks generally prefer safe bets. By following the 36% rule, you give yourself enough flexibility – at least in the bank’s eyes – to cover any unforeseen emergencies without compromising your ability to continue making mortgage payments.
In general, mortgage payments are determined by a variety of factors: the price of the home, down payment, and your credit score (which determines your interest rate). If you know your credit score, you can use an online calculator to back-in to how much house you can afford under the 28% and 36% rules. Tools like this can be your guidepost when trying to determine how much house you can afford.
Other items to consider when calculating how much house you can afford include property taxes, homeowners’ insurance, and mortgage insurance (if you make a down payment less than 20%). Most people include (or escrow) these payments with their mortgage principal and interest. The 28% and 36% rules encompass your all-in payment, which is often referred to as “PITI”: Principal, Interest, Taxes, and Insurance.
The Bottom Line
For most people, their home is their largest financial asset. Regardless of the emotional weight and stress that can come when purchasing a home, it is typically best to make a decision based on facts and numbers. If you already have other debts, (like student loans and/or a car payment), it’s especially important to know and understand your take-home budget so you are not burdened with a mortgage that you cannot afford – or the guilt and anxiety that could potentially come with it. So if you’re asking yourself, “how much house can I afford”, just remember, the initial rush of excitement that comes with a new big, shiny house will inevitably fade away after a few weeks or months; but the guilt and anxiety of a burdensome mortgage will be with you for years, possibly decades.
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