For most people, buying a house is the single greatest investment they will ever make. This purchase decision has tremendous consequences for your financial and family life for years to come. A wrong decision here reverberates in almost all corners of your life.
So it’s important to make sure you can afford the home you want to buy. This includes not only the down payment and the monthly payments but also the taxes, insurance and upkeep. At the same time, you have to strike a balance because numbers aren’t everything. You also have to consider the location (of course) and the comfort factor. You might fall in love with the numbers, but if these other considerations don’t work, the purchase could turn out badly.
How do you find that balance? I'm going to outline a step-by-step process you can use to do just that. In part one, we'll look at how to calculate the maximum amount you should spend when buying a home. Assuming that you and your family agree that the house is in the right neighborhood and it will be comfortable to live in, let's make sure your eyes aren’t bigger than your wallet. (For more, see: Buying a Home: Cash vs. Mortgage.)
Calculating the Most You Should Spend
A good general rule of thumb is to make sure the purchase price of your prospective home is less than four times your family income after debt service. Let’s use an example to clarify: Assume you earn $100,000 a year and you have no debt payments. Using our rule of thumb, you could buy a house that costs less than $400,000 and be fine. But let's say you have credit card payments, student loans and car payments that total $2,000 a month. In that case, you should reduce your ceiling price to $304,000. That’s because $2,000 a month comes to $24,000 a year. And $100,000 less $24,000 is $76,000. Finally, $76,000 x 4 is $304,000.
Keep in mind that rules of thumb are just general guidelines. You might tweak this number if your financial situation could reasonably change (for the better or worse) in the foreseeable future. For example, if you are about to inherit a sizeable amount or are about to get a large raise at work, you might be comfortable spending more for your home. On the other hand, if things look shaky at work or you are going to have to deal with some large expenses such as college funding, you might want to scale back.
Another general guideline is the debt-to-income ratio. This number compares your gross income to your monthly fixed obligations (including potential mortgage payments). Prospective lenders like to see your debt-to-income ratio below 40. This is important to keep in mind because if you add up all your monthly expenses with the new potential mortgage expense and it works out to a number above 40, you may not qualify for the loan. It’s important to figure this out prior to starting your house hunting.
These rules of thumb are just our starting point. We need to go a bit deeper if we want to make sure your real estate purchase makes sense. In my next article, we explore the other costs that come with buying a home, and look at how to calculate whether you can actually afford to buy the home you're considering. (For the second article in this series, see: How to Calculate the Costs of Buying a New Home)