When you overextend yourself by purchasing a new home, something in your life will go down. For example, you might end up cancelling your vacation plans, reducing your contribution to retirement accounts, or delaying your college funds. And before you know it, the dream of owning a home has become a financial cage in which you are trapped.
When making a decision on whether to purchase a home, remember it’s more than just whether you qualify for a mortgage. It’s also about protecting your future way of life. Even if the payment makes sense on a piece of paper, if the payments you are required to make each month greatly affects your ability to achieve other goals and dreams, then you are overextending yourself.
The 30% Rule
One widely accepted rule of thumb is to spend no more than 25% of your after-tax income (take home pay) on housing costs, which are often referenced by financial speakers such as Dave Ramsey. Alternatively, some lenders might approve a mortgage payment as high as 50% of your gross (pre-tax) income.
Both of these guidelines do not take into consideration the actual dollar amounts of your income that contribute to your current lifestyle.
The After-Tax Income Method
Instead of worrying about how much money you make pre-tax, focus on the after-tax amount of money you have after all your taxes have been deducted.
For most people, according to the after-tax income method:
25% is considered to be very safe
30% is considered to be reasonable and sustainable
35% may be acceptable if you have a very high income and/or low other expenses.
If you earn less than $60,000 a year, it’s a good idea to keep your DTI ratio close to 25% because of your limited income and resources to repay your mortgage. But if you are a higher earner and have a habit of practicing self-discipline with your expenses, you be able to handle a larger percentage.
Just because the bank approves your mortgage doesn’t mean you should accept that amount.
Your mortgage payment is just part of the equation when calculating your monthly housing costs.
Many buyers make the mistake of calculating only the amount of their mortgage payment.
Not smart.
PMI (Private Mortgage Insurance)
You will stop paying PMI once you reach an amount of equity in your home, but until then you will incur an additional expense with each monthly payment.
HOA Fees
The amount of the fee can be modest to absolutely crazy. When you pay these fees, you are paying for things like landscaping, snow removal, trash pickup, sometimes utilities, etc. In some areas, HOA fees are comparable to car payments.
Consider a 2-earner household with a gross income of approximately $102,000. After taxes, they will take home about $6,500/month.
30% of their take-home will give a housing budget of approximately $1,950.
Now let’s assume the following housing expenses:
- Mortgage: $1,570
- Property taxes: $200
- Insurance: $100
- HOA: $80
- PMI: $170
Total: $2,100
This is over your 30% target.
At this juncture, reality sets in, and you may need to:
- Decrease the purchase price
- Increase the size of your cash down payment
- Use a longer loan amortization
- Accept the increased percentage and eliminate other savings goals
It all comes down to a balancing act – no spreadsheet can help you with this decision.
Choosing Between a 15-Year and a 30-Year Loan
You will save a considerable amount in total interest by getting a 15-year mortgage over a 30-year mortgage; however, your monthly payment will be higher.
If you take a 30-year mortgage, your monthly payment will be lower than with a 15-year mortgage, but you will pay more total interest over the life of the loan.
A shorter loan term means more pressure and faster repayment but less flexibility, whereas a longer loan term means less pressure and more flexibility but requires a longer time commitment.
Ultimately, your choice will be influenced by your priorities, either flexibility today or long-term savings.
Gross Vs. Net Income: Important Distinctions
For budgeting and planning, using your after-tax monthly income is the best way to create a realistic budget.
It is, “What Can I Afford, Without Regrets?”
If “owning a home” results in:
- No retirement savings
- No emergency fund savings
- No/enjoyable vacations
- Ongoing high anxiety level
Then whether or not you can afford the home does not mean you should own it.
Homeownership is a security, not a burden.
Let’s say:
You purchase at the top of your acceptable price range. Everything runs but hardly.
Then:
- You have an unexpected bill.
- You lose a job.
- You get a baby.
- You have an expensive to repair.
If you face a disruption and cannot meet your budget, you probably over-extended yourself financially.
When you buy a house, it should have a margin of safety to allow for other potential expenditures (retirement, surprise bills, living).
So, how much house should you buy?
Here’s a practical way to determine what you can afford:
- Use your after-tax monthly income.
- Multiply your monthly income by 25% – 30%.
- Include all housing expenses—mortgage, taxes, mortgage insurance, homeowners association dues, and utility bills.
- Use conservative estimates of property tax and homeowners insurance.
- Allow for savings, investments, and some of your everyday expenses.
If your housing payment (including all costs) is less than 30% of your monthly income, you likely can afford to own a home.
If you are approaching 35% of your monthly income for your housing payment(s), proceed with caution.
If your housing payment(s) exceed 40% of your monthly income(s), you may be making a lifestyle choice that inhibits your financial well-being.
Buying a home is a tool to help you create a great life for yourself, not to replace your life.
Impressing the bank is not one of your goals; your goal is to provide yourself with financial stability while enjoying your money.
If you can go to bed each night knowing that you are able to save, invest, and take that family vacation from the money left behind after paying your mortgage, you likely have purchased the appropriate amount of housing.
If you cannot sleep soundly at night, you may want to re-evaluate your financial calculations before you make an offer on a home.
