Some of our most asked questions center around home-buying and the involved processes. When we think about it that makes perfect sense. The item in your budget where you’re likely to spend the most is your primary residence. Buying a house is a huge undertaking. If you think you’re ready to take the plunge there are lots of things to know.
You need to know how much house to buy, how you’re going to finance the purchase, who’s going to help you look, and on and on and on. That’s why we decided to launch this mini series. We do have other resources available which discuss home buying. However, our goal with this series is to discuss the home buying steps in depth, one at a time. The process can be overwhelming so our goal is to break down the process into more bite-sized steps.
Step 2: Determine How Much House You Can Afford
You need to know how much house you can afford. First, let’s start with who shouldn’t help establish your budget: your agent or your lender. Each of these parties has a specific role to play and having a seat at the table where you establish your budget isn’t one of them. There’s a method to the order in which we wrote these posts. Finding an agent and lender are posts 3 and 4 respectively for a reason. Your budget should be set long before you meet with either of these people.
Let’s start with your agent (often called a Realtor). Though your agent should have your best interests in mind, they are still paid on the seller’s commission. Your agent isn’t financial counsel. They don’t get paid unless you buy and the more you buy the more they make. This isn’t to say your agent is only looking for a check. But allowing them to show you homes based on what they think you can afford is a big mistake. You should tell your agent a firm price range and they should only show you homes that fit your budget. There are few things more financially dangerous than falling in love with a house you can not objectively afford. In fact, if your agent shows you houses outside of your budget, especially without letting you know first, find a new one. I digress.
The other party who shouldn’t be involved in establishing your budget is your lender. Again, your lender is interested in closing a loan. They aren’t trained to advise on what you can objectively afford. They only need to make sure the loan falls within their underwriting criteria. Again, lenders aren’t bad people. But your financial health isn’t their number one priority. A lender is likely going to loan you anywhere from 30% – 40% of your gross income (depending on your credit score). We recommend you spend 25% of your net income on your house.
Let’s look at an example:
Sam and Brittany want to buy a home. Their gross income is $100k. After taxes their annual net income (take home pay) is $80k. They have no other debts.
|Lender||Your $ Line|
|Monthly Income (take home)||$6,667||$6,667|
|Amount Remaining (after mortgage is paid)||$3,334||$5,001|
As you can see, if Sam and Brittany stick to our recommendation they’ll have $1,667 more available to fund their everyday life. These funds can be used for home repairs, college savings accounts for children, and more. We’ll discuss the types of mortgages and interest rates in part 5. …But quickly I want to touch on an exception (or two) to our 25% rule.
If Sam and Brittany were hoping to take out a 15 year mortgage instead of the more common 30 year mortgage, we would increase our recommended percentage. A 15 year mortgage will mean a higher monthly payment but they will be mortgage free in half the time. If Sam and Brittany choose a 15 year mortgage they could increase their budget to closer to 30% of their income. There is one other exception to our general 25% rule: location.
Location, location, location. It’s common knowledge that you can buy a lot more house in the midwest than you can in Manhattan. If you are living in a high cost city (think Portland, San Diego, San Francisco) it’s not likely you’ll be able to keep your mortgage payment under 25% of your net income. The most important thing is that you understand this is a tradeoff. You only have so many dollars to spend each month and the more you spend on housing the less you have for other areas in your budget like food, entertainment, and transportation.
A key point in knowing how much house you can afford is determined by your other monthly obligations. The amount of house Sam and Brittany can afford changes dramatically if they have a car payment or two, credit card debt, or student loans. Most households carry debt, so let’s assume they do too.
As it turns out, Sam has student loans. Sam’s monthly student loan payment is $450. This amount needs to be withdrawn from their monthly take home pay before they determine the 25% payment.
$6667 (take home pay)
– $450 (student loan)
$6217 (new net)
X .25 (25% budget)
$1554 (new monthly budget)
As noted above, Sam’s student loans will decrease their budget by ~$112/month. This example shows us that the more consumer debt you carry the less house you can afford. Of course, there is more to owning a home than just paying the mortgage.
Your monthly budget needs to cover at a minimum your principal, interest, taxes, and insurance (PITI). Depending on where you’re hoping to buy some of these components might impact your budget more than others. There’s a balancing act between each of these expenses. For example, some states have higher property taxes than others. In states like New Jersey, Illinois, or New Hampshire your property taxes will mean you can afford less house than in states like Hawaii, Alabama, or Louisiana. Insurance might also impact your monthly budget if you live in a state more susceptible to natural disasters. In Alaska or California you might need earthquake insurance. A Florida or North Carolina buyer might need flood insurance.
Finally, the last (major) consideration in your budget which is the condition of the home you’re hoping to buy. Maybe you want a new build? Perhaps you have an eye for old charm? Have you watched enough HGTV to think you can tackle a fixer upper? A new home might come with less monthly surprise expenses. It’ll likely be more energy efficient, it won’t need cosmetic upgrades, and the major appliances will be new. Of course anything can still go wrong, even with a new build. But your chances of needing to fund a major repair are significantly lower. If you’re hoping to buy an older home you might need to lower your budget to accommodate for repairs and updates. In addition, an older home might not be as energy efficient requiring you to plan for higher utility bills. Your overall budget should allow the use of 10% of your income for utilities. However, if your home isn’t energy efficient you might need to decrease your housing budget to increase your utility budget. Turning a fixer upper into your dream home will require significant cash flow. If you’re unable to cut other expenses from your overall budget you’ll need to lower your mortgage budget to accommodate. Home renovations can equate to major dollars.
Again, there is a balancing act between all of these expenses. You need to be aware of costs that might impact your budget due to type of home, geographic location, etc. Remember, the Ideal Budget is a guide. It doesn’t have to be followed to a “t.” But, changes to the Ideal Budget do need to be intentional. If you plan on increasing your housing budget know where you’ll need to decrease your spending to achieve a balanced budget. Once you’ve established a budget you’re ready for the next step:
It’s time to determine exactly where you want to live.