Buying a house can be an exciting, stressful, exhilarating, anxiety-filled experience, particularly in our current market environment in 2020 and 2021. You may have visions of your future “forever home” which brings you excitement and enthusiasm, but there is that nagging question in the back of your mind of “what can I afford” or “how much should I spend?”
Let’s be honest here; a house is a big investment. In fact, it’s typically the largest investment someone makes during their lifetime so making the wrong decision can have major consequences. I’m often asked “how much can I afford” and since the housing market is such a hot topic (might have something to do with the historically low interest rates and staggering demand), this content seems appropriate and timely.
The Loaded Question
I’m calling the loaded question, “how much can I afford?” because there isn’t really one simple answer and often this question warrants many follow up questions to determine what is most appropriate. To break it down simply, there are two ways of interpreting this question, as follows:
1) How much can I get approved for from a lender based on my income, debt to income ratio, assets, credit scores, employment, etc.
2) How much can I actually afford based on my lifestyle decisions, risk comfort, other life goals, future plans, etc.
Notice the distinction between what a lender will give you and what you can comfortably pay each month, without unneeded stress.
Determining the Amount
When a client asks me “how much can I afford”, I will follow a certain process to eventually get us to an appropriate amount. This is what that process looks like:
1) First, I get a sense of the important factors that go into qualifying for a mortgage and ask questions such as:
a. What is your gross income (before taxes and deductions) as well as net income (after taxes and deductions)?
b. What is your credit score?
c. What current debts do you have?
d. What other non-debt obligations do you have (HOA fees, child support/alimony, etc.)?
2) Secondly, I will ask what they are currently paying in rent/mortgage and get a sense of the following:
a. Has that amount been working for you comfortably?
b. Do you have a roommate or anyone supplementing that payment?
c. Do you have excess dollars in your budget at the end of the month after paying all the bills, putting money in savings/retirement savings, etc.
d. What is the driving force for moving in the first place? Do you need a larger space for a growing family? Bored of your current location? Have high property taxes in your current location? Feel pressure to move because everyone else is moving?
3) At this point, I will share how many financial institutions actually determine what you’re able to afford. Of course, this is dependent on a myriad of factors like credit score, work history and/or current employment, etc. but one of the most important factors that lenders will use is your Debt-to-Income Ratio.
This ratio measures how much of your monthly gross income is made up of debt payments and obligations. Some lenders are more flexible or lenient (usually local or regional credit unions/banks) but as a general rule, D:I ratio should be 36% - 41% at most.
So, this means of your monthly gross income, only 36-41% can be tied up in debt/obligations. Remember gross income is before taxes and deductions but when you actually pay a mortgage, you are paying with your net income so don’t get caught in the trap of thinking that your gross income is what you take home each month. Let’s see an example in action:
a. Client A has a full-time W2 job (is not self-employed) making $50,000 per year. Her monthly debts are as follows (1) Student loan: $300 and (2) Car loan: $250. Her current D:I ratio would be $300 + $250 = $550 (debt payments) and $50,000/12 = $4,166 (gross monthly income) so $550/$4,166 is 13.2%, well under 36%. If you take 36% of $4,166, you get about $1,500 so this means that her mortgage and all of her debt payments cannot exceed $1,500 monthly and so her mortgage could be about $950 per month. As a general rule, $1,000 in a mortgage payment is about $200,000 in debt (again this depends on property taxes/location, interest rates, etc. but this is a general rule of thumb)
4) So now that I’ve shared with the client that they can afford about $200k in a mortgage, is that what I recommend? Absolutely not. I may recommend that this person could go up to the 200k, but remember this does not take into consideration the person’s lifestyle expenses and/or risk comfort, or goals for moving in the first place. We also haven’t even discussed down payments, which she would be responsible for usually at least 5% ($200,000 * 5% = $10,000). There are many factors that go into determining what is an appropriate amount to spend on a home and it’s not simply what they can afford from a lender. This is where the real discussion and financial planning start.
This post isn’t intended to make anyone feel like you can’t afford the house they want, but instead is meant to show that it isn’t just based on the science of debt-to-income ratio. There are many quantitative and qualitative factors that go into deciding a mortgage amount. While someone who has a very thrifty lifestyle, great savings habits, and job security may purchase at the top of what he or she is able to afford, someone else who is used to paying a relatively low rent payment and has certain hobbies and/or lifestyle needs that don’t allow for a more expensive mortgage may not be able to afford the top of what they can get approved for.
Always work with a financial professional when determining what makes the most sense for your future home purchases. Don’t have one? Reach out to Minerva Wealth Planning at firstname.lastname@example.org or schedule a free consultation on our website.
Our blog posts are never intended to be specific advice and we use general metrics that lenders use but keep in mind specific lenders may have their own formulas to determine what is affordable. Always talk to your financial professional and lender to determine facts for your specific situation.