How to calculate how much house you can afford

Authors: Motley Fool Staff
Source: The Motley Fool

There are few things more exciting than buying your first home. Whether it's a downtown loft or a country cottage, you knew it was meant to be yours the first time you saw it.

Not so fast.

It can be tough to separate emotion from wisdom when it comes to buying a home. After all, this is the place you picture yourself building memories with the people you love. If you find a home that matches your fantasy, it can be intoxicating enough to throw caution to the wind. Which may mean you commit to paying for a larger house than you can afford.

Why caution matters

We all want to live in a home that makes us glad to get back at the end of a long day. We want our home to be a nest that makes us feel warm and safe. However, the reality is that too many homeowners have nests that cost them too much.

Budgeting based only on the good times is a recipe for foreclosure. Recessions arrive with some regularity. If you're not careful, once-in-a-century pandemics (like this one) might catch you sleeping on your finances. When you buy a home, you'll need to do more than make the monthly payment. You'll need to keep up with all the costs of homeownership and weather downturns in the economy as they occur. Below, we'll walk through two different ways to think about monthly mortgage costs relative to your income.

The 28% rule

There are at least a dozen formulas for the ideal housing expenditure. The 28% rule is one of the most common. It says you should spend 28% or less of your gross monthly income on housing-related expenses.

Let's say you earn $60,000 per year or $5,000 per month. That means your total housing costs should be no more than $1,400 ($5,000 x 0.28 = $1,400). This total should include:

  • Mortgage principal and interest
  • Taxes and insurance
  • Private mortgage insurance (PMI), if necessary
  • Condo fees

This is called the front-end ratio. It's one of two debt-to-income ratios (DTIs) used by mortgage lenders to determine whether you can afford to purchase a home.

The 36% rule

The second DTI is called the back-end ratio and encompasses your total monthly housing costs as well as any existing debt payments and obligations, including:

  • Housing (including principal, interest, taxes, insurance, and PMI when applicable)
  • Loan payments (like auto, boat, and personal loans)
  • Child support
  • Spousal support
  • Credit card debt

Applying the 36% rule to the $5,000-per-month scenario, your total monthly payments should be no more than $1,800 ($5,000 x 0.36 = $1,800). Some mortgage lenders will allow a higher front-end or back-end ratio but if your new home will push your spending over those limits, you need to make sure you're not over-stretching your finances.

Additional expenses

You can count on things to break in and around your home. Whether it's a garage door opener or a water heater that goes on the fritz, making repairs is an unavoidable part of homeownership. Here are two good ways to plan for maintenance.

1. Plan on spending at least 1% of your home's value each year to keep things operational. If your new home is valued at $300,000, this means putting away $3,000 a year (or $250 per month) to cover repairs.

2. Put aside 10% of your total mortgage costs each month for repairs. If your total mortgage payment (including principal, interest, taxes, and insurance) is $1,400, tuck an extra $140 into an emergency account to pay for upkeep.

Also, ask your real estate agent to show you tax records for the past five years on any property you are considering. How quickly the property taxes have risen in the past may be a good indicator of how quickly they will increase in the future. Request copies of utility bills for the past six months, just in case those expenses run higher than expected. The goal is to do everything you can to avoid buyer's remorse.

Regardless of how much your home costs, it's a good idea to have three to six months' of living expenses tucked away in an emergency fund. That way if you fall ill or lose your job, you will still be able to keep up with your mortgage payments.

Before you fall in love

If you want to create a warm nest for your family, but also want to sleep well at night, determine how much you can afford to spend before you shop for a home. Better yet, decide how much you want to spend. No rule says you must spend the entire 28%. The less you commit to each month, the more you can save, and the easier it will be to hold onto your home when the economy dives, you lose a job, or are hit with unexpected medical expenses.

There is a satisfaction to be found in purchasing a home that costs less than you qualify for and slowly making it your own. In addition to the personal fulfillment, any home improvements you make can help build equity that can benefit you in the long run.

Few experiences measure up to moving into a place of your own. The only thing that could make it better is moving in with the knowledge that you have plenty of money left each month to have fun today, save for the future, and protect your investment.