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How Much House Can You Afford?
When buying a house one of the first steps that you will need to take is to get pre-approved for a mortgage. This is usually a very quick process. You answer a few questions, provide your basic information and the bank spits out a reply.
Congratulations! You have been pre-approved for a $2,300,000 mortgage!
The pre-approval process is a joke. Please, don’t go shopping for a $2,300,000 house. The pre-approval process is easy and does not require pulling your credit score. I just jumped on my bank website and did one real quick just to see what response I would get. I am not approved for $2,300,000 but I still got an absolutely ridiculous number.
Typically, the formula that banks use is your monthly gross income less your monthly debt payments, multiplied by 35 to 40% (my bank actually used 43%).
So if you made $50k/year ($4,166/mo.) and had $1,000 of monthly debt obligations your formula would look something like this:
|Gross Monthly Income||$4,166|
|Less Debt Payments||($1,000)|
|Lender Max Debt to Income||40%|
|Potential Max Payment||$1,266|
|Less 20% for Taxes and Insurance||$1,012|
Based on these numbers the bank believes that you can afford a $1,012 monthly principal and interest payment. If you stretch this out to 30 years based on today’s rates this comes in close to $265,000. All of these numbers are just principal and interest. This assumes that you are putting 20% down and that your taxes and insurance are only $254/mo (I wish!).
Pro Tip: If you make $50k/year and still have $1,000 in monthly debt payments you have no business buying a $265,000 house unless you can pay for it in cash.
Just because something is available to you does not mean that you should do it. Just because you are approved for a $500,000 house does not mean that you should buy it.
I Truly Believe That Home Ownership Is A Great Thing
Yes, it has its pitfalls and yes, depending on where you live it can be very expensive to own a home, but in the end I think it is a wise investment.
If done properly.
Growing up I shared a bedroom with my older brother. It was awesome. We did everything together and made many memories since we spent so much time together. Nowadays, when I tell someone that two of my kids share a bedroom I get this look like I’m a bad parent or something.
I promise you, two siblings sharing a bedroom is not going to hurt them. In fact, it may be a great thing for them long-term. They will learn how to share, how to get along with others and it might even prepare them to have a roommate someday!
Needs Vs. Wants
Their has been a gradual mindset shift overtime in regards to needs and wants. I NEED a roof over my head. I do NOT NEED my own bedroom. This mindset shift has not only taken place in housing but in just about every other area of our lives. People believe that they need an SUV or minivan as opposed to a sedan (do they even need a car?). People believe they need a 60″ TV.
I look at it as a maximum vs. minimum scenario. When borrowing money we need to look at what is the least amount of money I can borrow and still get what I need. Not what is the most that the bank will let me borrow so that I can get what I want.
Related: The Reality of Frugality
Now if you have the cash to buy a $500,000 home then I am not going to argue with you too much. That better not be all of your cash though.
It’s A BIG Decision
I would venture to guess that a home is the biggest purchase that 90% of Americans will make in their lifetime. I have done no research on this, it’s just my guess. But, not only is it the single biggest purchase but it will also most likely be the most costly ongoing expense in their lives. In other words, don’t rush into this.
There are many formulas out there for figuring out how much house you can afford. Dave Ramsey says that your house payment (including insurance and taxes) should not exceed 25% of your take home pay. This is probably not a bad standard for the average person… if you want to work until you are 65.
So what is the right amount? How much should you actually spend on your mortgage on a monthly basis? It is hard to pick a percentage of your take home income because there are so many other factors at play including how much you are contributing to your 401k, HSA, etc.
Related: Is Your Emergency Fund Big Enough?
There has to be some standard though. For me, I prefer to go all the way down to a maximum of 10% of your gross income. That is your total house payment including taxes and insurance. Some people are going to come unhinged when they read this and tell me I’m crazy.
“I would have to live in the worst part of town in order to spend less than 10% of my income on housing!!!”
I get it. Every market is different.
But do you really NEED to live in that fancy part of town or do you just prefer to?
I would consider the area that I live to be very middle-class. Maybe even lower middle-class. Most people around here work blue-collar type jobs. The houses are smallish. They make great starter homes, or even forever homes.
Did I want to live in the upscale neighborhood with the big houses and the big yards? You bet I did. I still do. It sounds great. But it’s not worth what I would have to give up to do that.
Coming Back Full Circle
The title of this post is How Much House Can You Afford? It’s kind of a trick question. I think the more proper question that you need to ask yourself is how much should I spend on housing? Housing should be looked at from a minimum point-of-view, especially if you are taking out a mortgage. Becoming a homeowner has many great benefits but it is not the ultimate answer to long-term wealth building. Buying a house is not for everyone. There are some instances where renting long-term makes more sense.
If you can’t purchase a home with payments that are less than 10% of your gross monthly income you basically have one of three options.
Option One: Save for a bigger down payment to reduce your monthly mortgage payment.
Option Two: Move to an area where housing is cheaper. This is generally not a popular option. But is living in a high-priced city so important to you that you are willing to sacrifice your long-term financial future?
Option Three: Continue to rent indefinitely.
Is Renting Long-Term A Wise Decision?
I am honestly not a huge fan of the renting forever strategy. There are so many things with renting that are out of your control and having control is extremely important to me. There are certainly some benefits to renting but in the end it all boils down to lifestyle choices.
What are your thoughts on this? Is 10% of gross income a good standard?
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