Right now, home prices are low, and mortgage rates are attractive.
As a result, the temptation to buy is great, especially for first time homebuyers who want to get in now, while they can save big.
However, just because you think now is a good time to buy does not mean that you should. Make sure you know how much house you can afford on your income before you jump in.
The 25% of Salary Rule of Thumb
Here’s a question I recently received from a friend and reader about how much house he could afford on his income. He referenced Dave Ramsey’s rule of thumb about not having a mortgage payment for more than 25% of your salary:
I have a Dave Ramsey question, PT. I’ve Googled around and cannot find the answer, and was wondering if you knew. Ramsey states that you should spend no more than 25% of your income on your mortgage. Do you think he wants you to calculate property taxes and insurance in your “mortgage payment,” or do you think he is simply calculating principal and interest?
In my answer I said, “yes, Dave definitely wants you to include it.” The second comment on this post suggest that he said so specifically in one of his newspaper columns. Further, taxes and insurance are guaranteed, so you should consider it.
I went on to say that a rule of thumb is limited in it’s simplicity. For instance, I can go out and get a adjustable or variable rate mortgage payment that’s less than 25% of my take home pay today, and tomorrow the housing market could crash another 30%, rates could go through the roof, and I could lose my job. Owning the home outright as quick as possible is sounding like a better rule for the future.
How Much House Can I Afford??
There are a number of things you can do to reduce the cost of your first home, but you still might not be able to handle the costs of homeownership. Let’s look as some ways to help determine the answer to the question, “how much house can I afford?”
In some cases, your mortgage plus interest may be more than your current rent payment. But that’s not all. As we mentioned about, homeownership comes with other costs, including:
- Property taxes: You will need to make property tax payments. Whether a yearly lump sum is due, or whether you pay monthly with your mortgage payment, this is something to prepare for.
- Maintenance and repairs: No longer can you have the landlord bear the cost of maintenance and repairs on your dwelling. You are responsible for the costs associated with keeping up the home, and taking care of it. This can cost more than you might expect.
- Utilities: Many people forget to consider the extra costs associated with a home. In many cases, your home is larger than your rental. This means that it will cost more to heat it. Electricity and water costs are likely to go up as well. And, if your landlord previously paid sewer and garbage collection costs, these are additional expenses.
- Falling home values: When you are renting, your landlord bears the cost of a falling home value. If you buy, though, you could find yourself underwater — especially if your down payment was small. Are you prepared to take the risk that your home will decline in value?
Test to Find Out What You Can Afford
Before you buy, it is a good idea to go for a “test run” with the increased costs of home ownership. One thing you can do is take 30% of your expected mortgage and interest payment and add it back on. So, if your expected mortgage and interest payment is $1,100, add $330 so that your total estimated monthly costs are $1,430.
Then, consider the difference between what you pay now for your rental and the estimated cost. If you pay $850 in rent now, it means that you will pay an extra $580. Can you afford that much house? Let’s find out with a real savings test.
Next, open a high yield bank account. Put that extra $580 in the account every single month. Do this for at least four months. Are you having difficulty making the new “payment”? If so, you might not be ready to purchase a home. The higher costs may exceed your ability to pay for them.
Before you buy a home, you need to make sure that you are truly ready to shoulder the costs. Otherwise, you will be house poor, and your monthly cash flow will be strained. You could end up in a worse position than if you continued to rent.