In our society, one of the biggest financial milestones is often combined with a major life milestone. The purchase of a home is still part of the “American Dream,” and many people view a home purchase as a mark of adulthood.
Unfortunately, one of the problems with making homeownership a major milestone in life and finances is the fact that many people get pushed into buying before they can afford. And, even if they can afford to buy, it’s tempting to purchase a home that isn’t really affordable.
Before you decide to start house hunting, take a look at your finances, and decide how much you can truly afford.
Rule of Thumb
Many potential homeowners like to have a guide that can help them quickly make decisions about what is “affordable.” To that end, there is a rule of thumb known as the 30 percent rule. According to this rule, your mortgage payment should amount to no more than 30 percent of your monthly income.
Of course, this “rule” still leaves the situation wide open. Should you figure it on your gross income, or your take home pay? What about property taxes and insurance? Should those be included? What about other costs often related to homeownership, such as maintenance and HOA fees?
If you want to make sure that you truly can afford a home, and you use the 30 percent rule, it makes sense to use the strictest interpretation possible. Take your PITI (principal, interest, taxes, insurance) and then add 10 percent to it to account for maintenance and repairs, figuring that total as a percentage of your take home pay.
So, if you make $4,000 a month, your total, according to the 30 percent rule, is $1,200. That means that your PITI should be no more than $1,080, if you consider that $120 of that total should be considered part of maintenance and repairs. You can also consider utilities as part of your 30 percent rule. If you estimate about $200 a month for utilities, that means that your PITI can be no more than $880 per month.
Once you have your monthly requirement for PITI, you can begin extrapolating how large a mortgage you can get. Your interest rate and your down payment will influence this calculation as well.
If you put $10,000 down on a home that costs $180,000 (for a mortgage of $170,000) and your interest rate is 4.5 percent, the principal and interest portion of your payment is $861.37. Once you add other costs, it’s likely to go higher than the $880, but it’s probably doable. However, if you only put $5,000 down and your credit means you pay 5.5 percent interest, you can only buy a home worth about $155,000.
What are You Comfortable With?
While the 30 percent rule is a good start, it makes even more sense to look at your finances and decide what you would be comfortable with. One way to do so is to “test drive” your monthly payment.
Perhaps you decide that you can handle paying $1,000 per month for your mortgage and other expenses. Right now, you live in a rental and your total housing costs are $750 per month. Owning a home would add $250 to your monthly expenses. For the next six to eight months, take $250 and put it in a high-yield savings account. Can you do so without stretching your budget uncomfortably? Do you need to tap into that savings account a few times to make ends meet? If so, you should reconsider what you can “afford” to buy and perhaps adjust your expectations.
Most homeowners are surprised to learn that buying costs more than renting. You might end up with what you consider an asset, but it will cost you more on a monthly basis. Do your homework and make sure that you really can afford the mortgage you get.