Buying a house is a massive investment that requires careful thought and planning. While it would be nice to select any house in the neighborhood, it’s imperative that you take the time to consider how much you can reasonably afford to spend and work backward from there. Otherwise, you’ll find yourself in the unfortunate situation of being house poor.
3 Ways to Determine How Much to Spend
Affordability means different things to different people, but for this article, we’ll use it to mean this: a purchase that comfortably fits in your budget and doesn’t require significant sacrifices in other necessary expense categories like food, healthcare, transportation, and existing debt. (If you don’t already have a monthly budget, now’s the time to develop one.)
With that being said, here are some different measurements and rules of thumb you can use to determine how much to spend on a house:
- Home Loan Calculator
If you have a monthly budget, you should know exactly how much cushion or margin you have to spend on housing. For example, if you’re currently spending $1,500 per month on housing and there’s an additional $500 of income that doesn’t get touched, you could theoretically spend as much as $2,000 per month on housing. Figure out what your numbers are and come up with a maximum monthly payment.
With your maximum monthly payment in hand, use a home loan calculator and play around with the numbers. These calculators typically ask for details like loan amount, loan term, interest rate, and other simple information. Manipulate them until you determine the maximum loan you can take on. While you don’t have to spend this much, it does provide you with some parameters.
- Debt-to-Income Ratio
Lenders often use a metric known as the debt-to-income ratio to figure out how much a borrower can afford. While it’s an imperfect calculation, it is a helpful equation to understand the big picture.
“You can calculate your debt-to-income ratio by dividing your recurring monthly debt obligations (such as your minimum credit card payments, student loan payments and child support payments) by your gross (pre-tax) monthly income,” Alex Silady writes for SmartAsset. “When your lender calculates it, that percentage will include your potential mortgage debt burden.”
Typically, banks never want a homebuyer to have a debt-to-income ratio higher than 43 percent. If a house would put you near or above this percentage, it’s probably too expensive. Ideally, you want to be below 30 percent. (However, it all depends on the specific details of your financial situation.)
- 25 Percent Rule
One of the most commonly used measurements is the 25 percent rule. This rule suggests multiplying your monthly take-home pay by 25 percent. This gives you your maximum mortgage payment. Thus if you bring home $10,000 per month, your maximum mortgage payment should be $2,500.
Financial gurus like Dave Ramsey suggest using the 25 percent rule on a 15-year mortgage (rather than the traditional 30-year mortgage). Most people don’t go this route, but you can if you want to be extra cautious.
The Benefits of Living Below Your Means
In today’s culture, people automatically assume that they should buy as much house as they can afford. The problem is that buyers generally equate affordability with their lender’s pre-approval amount. So if a lender tells them they can afford to take on a loan of $400,000, they nod their head and start shopping. The problem is that the bank’s version of affordability is often quite different than your own.
If you’re maxing out your budget just to get into a particular house, you’ll find yourself house poor. Sure, you may be capable of making the payments, but do you have enough money to save, invest, travel, and enjoy life? Probably not.
When buying a home, try to live below your means. That sounds boring, but it’s really the best way to live an exciting and meaningful life. When you spend less than you make, there’s margin in your budget to take a random weekend trip to the beach or buy Super Bowl tickets when your favorite team makes the big game. You can let your kids play in the travel soccer league or afford to fix your truck when it breaks down.
Because of the magnitude of the purchase, your house is the key to living below your means. Figure out how much you can reasonably afford and don’t go over it. It’s a wise decision you’ll never regret.
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