5 Factors to Consider in Determining How Much House You Can Afford

It is always tempting, perhaps especially in Northern Virginia and other high-cost housing areas, to believe that we can afford a more expensive house than may be wise financially. Let’s face it, the $600k home will always be nicer than the $400k home. However, those new appliances and granite countertops may lose their appeal if you can only afford to eat rice and beans on them after making your monthly mortgage payment. Here are a few factors to consider in determining how much house you can afford when buying a new home.

Monthly Payment Rules of Thumb. Two basic rules of thumb on housing costs stem from mortgage lender practices. Most mortgage lenders are hesitant to give loans if the total payment of principal, interest, property taxes, and homeowners insurance (PITI) will be more than 28% of the borrower’s gross income on a monthly basis. Additionally, they often do not want to approve a loan if a borrower’s total monthly debt payments (including mortgage, car loans, student loans, child support, payments on rolling credit card debt, etc.) amount to more than 36% of gross income. Of course, lenders are only concerned with whether someone will default on a loan–not whether their monthly payment will cause significant stress–so, it is very advisable to stay comfortably below those guidelines.

Applying the Rules of Thumb.  These rules of thumb, however, do not take into consideration the specific circumstances of the borrower, including how much of their income is used on discretionary versus non-discretionary expenses.  For example, if you do not have a spouse and/or children relying on your income, perhaps spending 28% on housing costs would not be too uncomfortable, whereas it might be for someone who has several mouths to feed, which will remain equally hungry in the new house.  To determine one’s comfort level for an increase in housing expenses, we generally advise clients to look at their current monthly housing costs as well as how much they could save on a monthly basis.  This amount becomes their target monthly payment, and they can use that number to back into a price range for the new house.  Usually, we recommend to clients that they start saving on a monthly basis the “extra” that they will need for their new mortgage.  We make sure they also account for a potential increase in utility and repair costs.

Don’t Forget the Lump Sum Expenses. Of course, monthly payments are not the only consideration for determining how much you can afford to spend on a new home. Especially for aspiring homeowners who are currently renting, saving for a down payment and closing costs might be a significant hurdle. Remember that if you cannot afford a down payment of 20% of the sales price, you might have to pay either a monthly expense for private mortgage insurance (PMI) or a higher interest rate on your mortgage, both of which would need to be factored into the PITI payment mentioned above. Also, if a buyer is unable to negotiate closing costs into the house settlement, he or she can expect to pay approximately 3% of the home value for those.

Tax Savings: A Glimmer of Good News.  There’s good news in all this? Yes, well, a silver lining, at least. All of the additional interest and property taxes that you will pay on your new home are tax-deductible under current tax laws.  Therefore, if you are in the 25% tax bracket for federal taxes and you expect to pay an additional $10k on mortgage interest and property taxes in your new home, you can expect a tax savings of up to $2,500.

Prioritize Getting the Lifestyle You Want, Not Just the Biggest House You Can Afford.  We have seen several clients strapped financially due to housing expenses.  Prior to purchasing a home, consider the other things you want to do that may take financial resources.  Perhaps you enjoy traveling or dining out, for example.  Maybe having a bit less house and lower fixed costs will allow you to continue to enjoy these things that are important to you.  There’s no point in keeping up with the Jones’s if the lifestyle you get isn’t what you wanted.  Also, having lower fixed expenses gives you flexibility if there is a job change, health issue, or other event that creates a financial shock.

Purchasing a new home is a very big financial decision, but hopefully these guidelines help you in determining how much house is affordable without creating significant financial strain. And, as always, we are here to help!