How much house can you really afford?

I wrote this post for my client SelectQuote about the coming spring house hunting season.

Turn one calendar page and it’s spring – prime time for the housing market to open exciting new doors after a long winter lock-down. 

If you’re planning to move this year, you may be dreaming of luxury kitchen appliances, soaring ceilings, spacious walk-in closets, granite countertops, wood floors and a three-car garage. But before you jump on the next tour of homes or contact a real estate agent, stop and ponder this question: How much house can you really afford?

A little homework ahead of your house hunt will help you set realistic expectations, save you time and ultimately land you in the right place without making you “house poor.” Increasingly, financial advisors recommend using the 28/36 rule to help determine how much house you can comfortably afford. 

Ramit Sethi, in his bestselling book, “I Will Teach You to be Rich,” spells out how to use the 28/36 rule to help you decide what is likely the biggest purchase you’ll ever make. This rule is also used by mortgage lenders to determine how much loan you can get. Here are the basics:

• Your maximum housing expenses should not exceed 28 percent of your gross monthly income. This number includes everything that’s bundled into your home mortgage.
• Your total household debt shouldn’t be higher than 36 percent of your gross monthly income. This is known as your debt-to-income ratio. 
• If your maximum housing expenses and total household debt are at or lower than 28/36, you should be able to safely afford the house you’re considering. 

Calculate Total Housing Expenses

Add up everything included with the mortgage: principal, interest, property taxes and insurance. If your prospective home is within a homeowners’ association, add the annual fees to get the complete picture. This bottom line should be less than 28 percent of your gross monthly income, Sethi advises. 

For example, if you earn $4,500 per month, your total mortgage should be no more than 28 percent,or $1,260 monthly. 

Calculate Debt Ratio

Add up the monthly debt you owe divided by your gross monthly income. Debt includes mortgage payments, credit cards, student loans, car payments, medical bills, etc. For example, if you earn $4,500 per month and have $1,500 in monthly debt, your debt-to-income ratio is 33 percent.  

The Bottom Line

In the above two examples, your housing expenses vs. debt ratio is 28/33. This is below the 28/36 rule, so you should be able to afford your targeted home. 

Saving for a Down Payment

Financial advisors recommend making the biggest down payment you possibly can for your new home – at least 20 percent. Then shop for a fixed interest rate 15- or 30-year loan and do the math. If your calculation falls below the 28/36 rule, the home is probably a safe purchase. 

But, still, life happens, so be conservative, rather than springing for that dream house that may bring financial trouble in the future. House hunting is an emotional experience. Many home shoppers fall in love with a property they may be able to finance, but truly can’t afford if life takes a sudden turn for the worse, such as losing a job, an accident, major illness or an expensive needed home repair. 

Setting a housing budget is crucial in the homebuying business. Serious financial evaluation, including pondering the “what ifs,” is essential to a successful home purchase. 

How to Help Your Home Search

An online calculator can help you determine your mortgage payment as you shop for your new house. Enter your anticipated loan information and the calculator shows your monthly payment for a fixed loan. It can also calculate the loan amortization, which is the schedule that describes the repayment of the loan principal over time.  

Enjoy the Adventure

Although you have much to ponder as you shop for a new home, if you do your financial homework first, you’ll eliminate some of the stress of the search. Work with a recommended licensed real estate agent to get valuable free advice about how to evaluate and compare various homes you’ll visit. Happy house hunting – your ideal-home-for-now may be well within your reach.