Another common email I receive from readers concerns whether or not the sender can afford a particular house – or how much house they can afford. The stories vary a lot in detail – some people have a down payment, while others do not, and some people have other debts, while others are debt free.
Regardless of the situation, though, I give these people the same advice. Your total debt payment for a given month should not exceed 30% of your take-home pay.
In other words, if you bring home $4,000 per month, your total debt payments for that month shouldn’t exceed $1,200.
Let’s walk through a few of the specifics here.
This is take home pay, not gross pay. The only pre-tax number you might consider including is your 401(k) contributions, but I wouldn’t include those. I would never include taxes or other costs when thinking about this. Why? In the end, this is all about budgeting, and having 30% of your monthly income go straight into debt payments is a pretty hefty chunk of your money. This leaves the rest to cover utilities, food, household supplies, and other living expenses.
The percentage should be pretty close to that even if you’re earning a lot of money. Again, why? This is all about downside. You don’t want to have to sell your home in a panic if you lose your job or some other major lifestyle change occurs. You want to keep yourself afloat no matter where your ship goes.
Sticking with this policy usually implies a few things.
First, you’re going to be able to afford a bigger home if you’re debt free. If you’re still paying hundreds per month in student loans, the burdens of home ownership are going to be intense. If you want a home in the next several years, focus hard on freeing yourself from debt.
Second, you’re usually better off if you buy a smaller home rather than a larger one. Once you get beyond a certain point of home size, the excess space mostly just serves as storage for your excess stuff – mostly stuff you don’t really need.
When Sarah and I were house-hunting, we fell in love with a house that was about 50% larger than the one we ended up purchasing. We both just loved this house. We tried to find a way to afford it but, when we sat down and were realistic with our financial situation, we knew we couldn’t really afford it. We bought a smaller house, one within the range of what we could afford.
Guess what? We’ve never missed the extra space. In fact, as we’ve been designing our “dream home,” it’s not much bigger than the one we have now. It’s mostly just rearranged.
Third, overburdening your short-term future with expenses is a huge mistake. When you sign up for a mortgage, you’re signing up for a pretty hefty addition to your monthly pile of bills. Likely, when you sign up for them, those bills are within your ability to pay them each month.
The catch comes if something changes in your life. A job loss or a serious accident can derail lots of things in your life – and the last thing you need on top of those is a difficult decision about your house when you’re unable to pay for it. It’s not worth it.
Finally, a down payment is a tremendous help here. Not only does it reduce the size of your mortgage by 20%, it also likely reduces your interest rate. If you charge ahead without a down payment, depending on the bank, you’ll wind up either with one mortgage for a somewhat higher interest rate covering the whole house, or you’ll wind up with two mortgages, the second one charging a much higher interest rate. In both cases, you’ll also likely have PMI, which amounts to another monthly bill that you won’t have if you simply have a down payment.
Yes, saving $40,000 for a down payment on a $200,000 home seems difficult, but it’s the right approach for the long term. After all, if you find it difficult to save a healthy chunk each month, how will you be able to survive as a homeowner?
Given these factors, I strongly feel that a safe approach to the question of “how much house can you afford” is the right one.