Buying a house is exciting and stressful, and there are infinite factors to consider, such as school systems, neighborhood, square feet, commuting time, etc. But the starting point for just about everyone is the same—determining how much money to spend. Most people come up with a range, or a ceiling, for what they are willing to spend. The problem is that too often people buy a home they can't really afford, end up completely house poor. Usually your home will be the biggest purchase in your life (how often are you throwing down $500K on a purchase?). So one of the most important financial decisions you will ever make is: How much house can you really afford?
Step 1: Mortgage loan pre-approval
Anyone who has bought a house or is in the process knows the feeling of getting prequalified. Often, the actual results come as a pleasant surprise. “Wow, you don’t say? I’m approved for a million dollar home? Well, I didn't think I could afford that, but you're the finance expert…" You may be excited that you can actually afford more home than you originally thought, but keep in mind the bank is a business and their goal is to maximize their profits. They will give you the highest loan amount they possibly can because the more money you borrow, the more interest they make. To understand why you should not just rely on the amount the bank will loan you, let’s look at the formulas lenders use to help determine the pre-approved amount. Although all lenders vary, and other factors like credit are important, most have a similar range for below:
- Mortgage payment ratio: One general rule banks use is your monthly mortgage payment should not exceed 28% of your gross monthly income. For example, if you and your spouse bring in a total gross income of $100,000, your monthly mortgage payment shouldn’t be more than $2,300 (($100K*0.28) / 12).
- Debt-to-income ratio (DTI): Lenders also look at your DTI, and want your debt-to-income ratio not to exceed 36% (some will go higher). Your debt includes your future housing payment, your auto loan or student loan payments, and minimum credit card payments. So if you and your spouse bring in a gross income of $100,000 a year, you shouldn’t be spending more than $3,000/month on total debt payments (($100K*0.36) / 12).
The problem doesn't lie in these equations, as the 28% and 36% rules are widely used by financial experts. The problem is that banks don't take into account monthly expenses such as utilities and child care when determining your maximum approval amount. They aren't looking at your spending habits, how long you plan to live in the house, or what your new home expenses will be. So when you get that magic "pre-approved loan amount" from the bank, remember it’s the first step in your analysis.
Step 2: Calculate new home expenses
The bank will give you a loan amount based on the amount of monthly payments they determined you can afford. They aren't taking into consideration all of the new expenses that may come along with your new place. If you buy a house that needs some work, your home repair and renovation costs may be substantial. On the flip side, if you upgrade to a bigger house, you are sure to have increased expenses.
Step 3: Review your budget
If you don't have a budget, or if yours is more of a guesstimate at your expenses, now is the time to really get an understanding of your spending. Start by listing all income sources and totaling these amounts. When figuring out your monthly expenses, look at the past three months from checking and credit cards. Separate the expenses into fixed and discretionary. Fixed are expenses you have to pay each month and are usually consistent amounts, such as mortgage, utilities, rent and car payments. Discretionary is everything else. List all the fixed expenses and the average you've spent on them for the past three months. Categorize each discretionary item in groups such as food, gas, entertainment, clothes, baby supplies, household, travel, transportation, etc. List each group on your spreadsheet, with the average you’ve spent on each over the past three months.
An important note here. Don’t overextend yourself on new home payments at the expense of your retirement and/or savings. So once you are finished with the above expenses, be sure to add a line item for savings.
Step 4: Analyze
Once you've finalized your budget, factor in the amount you are planning to pay on a new mortgage, plus the new home expenses you calculated in Step 2, and ask yourself the following questions: Is this monthly payment realistic? Are you going to feel stressed or feel you are living paycheck to paycheck? Will your retirement suffer? Are you secure in your current income? Do you foresee any additional/substantial expenses coming your way in the next few years (If, like many people buying a new home, you are planning to soon start a family, the answer here is a giant yes!)? The most important part in the process is to be honest with yourself on what you can afford. Make your new home mortgage work within your budget, not the other way around.