I’m about to start house hunting for my very first home. But before I do, I’m curious: How much house can I afford?
The most dangerous thing you can do when house hunting is to not know how much you can afford ahead of time. This is because your emotional response to a space can easily cloud your better judgement, and what you want might not align with what you can afford. To make matters worse, many banks haven’t seemed to learn their lesson from 2008 and today are back to their old tricks of luring and misleading borrowers with pre-qualification teasers and offers for adjustable-rate or interest-only mortgages that are actually beyond their means.
Being house-poor is no fun and can quickly lead to racking up loads of unnecessary debt or, even worse, foreclosure and bankruptcy. So it is important to do your homework ahead of time to find out exactly how much house (and related expenses) you can afford to avoid getting under a roof that is way over your head.
The general rule of thumb is that your house shouldn’t cost more than two and a half times your annual salary, and your mortgage payment should not exceed 28 percent of your net monthly income (after taxes and other deductions). Lenders keep these calculations in mind when examining your finances and credit history to help determine how much they are willing to loan you. You can do your own calculation here.
However, I like to take a more conservative approach and recommend that your total monthly housing expenses — including mortgage or rent payment and any applicable taxes, insurance and dues — do not exceed 28 percent. And don’t forget to consider and budget for the added cost of utilities and potential repairs or improvements (which is typically higher for older homes). This way, in the event of an unexpected emergency such as a job loss or income drop, disability, illness or death in the family, keeping up with your monthly expenses won’t add to the stress as much. Of course, before you buy a new house, you should already be free of excessive high-interest credit card debt and have at least three months of income saved in a separate account for emergencies.
Buying a house well within — and ideally, below — your means is smart for many reasons, including giving you the ability to save more toward other financial goals, indulge in the occasional splurge without as much guilt and make valuable home improvements. Knowing the max amount that you can afford to spend on housing and then narrowing your focus on properties that cost less than that is the best way to go.