How Much House Can You Afford?
July 17, 2010
When you’re buying a home it seems there’s always a price difference between the property you want and how much house you can afford.
As we’ve looked at houses we’ve seen examples of people who took out a home loan they obviously couldn’t afford and are now struggling to pay the mortgage on the house. Some of those houses are now up for short sale or even in foreclosure.
Buying More Than You Can Afford
In some cases it was a first time home buyer who wasn’t exactly sure how to buy a house that would fit into their budget long term. A few years ago they could put no money down by taking out a second mortgage to cover the down payment and paying only the closing costs.
Known as an 80/20 loan, it allowed buyers to avoid private mortgage insurance and let them do 100% financing on a house. Even worse some people would go with adjustable rate mortgages (ARM) to make their payments lower so they could afford a more expensive house. Unfortunately we all saw what happened when the ARM rates adjusted and so many people were unable to make their house payments.
Bank Financing Rules
Banks are much tighter with lending these days so it’s harder to get approved for a home loan. The system doesn’t make it as easy as it was to borrow more than you should but if you have a good credit score and low debt you can still get a loan for more than you can afford.
The loan officer who worked on our mortgage pre-approval told me on the phone she could approve us for $200,000 more than we were asking for based on our credit score and debt to income ratio. Even though we’ve been careful with our savings and credit over the last 10 years, it doesn’t make sense financially for our family to be borrowing around a half-million dollars for a house. Keep in mind that what the bank approves you doesn’t mean that you can afford it.
Mortgaging Your Future
Deciding how much house you can afford depends not just what the bank thinks of your finances but also what your plans are for the future. Simply because you can afford a house this year doesn’t mean that you’ll have enough money to make payments two years from now.
Say, for instance, you’re a two income family but one parent wants to stay at home once you have kids. You might be able to afford the house you want now but what will happen a few years down the road when the kids show up?
As an example, there’s a house my wife would love to buy that meets all of our criteria but one, it’s just too expensive. We could afford it if my wife went back to work, but she wants to stay at home with the kids while they’re young. If we’d have bought a more expensive house 10 years ago, she wouldn’t have that option now.
There are many reasons why your income might change in the future so be sure to consider those when evaluating a house. If you take out a big mortgage it could limit your options later on.
Being House Poor
Borrowing more money than you should for a mortgage can affect your present, not just your future. The term “house poor” is used to describe a person or family who bought near the top of their price range and spends all their money paying the mortgage, interest, insurance, and taxes.
We were house poor when we bought our home 10 years ago and it was kind of stressful at times. We had a nice new house but no money to buy furniture for it. When our friends invited us out we had to decline since we had no money.
This can be tough not just from a comfort standard, never having any extra spending cash, but also if you hit hard times you don’t have a cushion. Fortunately for us we were at the start of our careers and our earning ability increased to match the monthly mortgage payment we owed.
Beware Pressure to Buy
When you’re in the market for a house the pressure is always there to buy a bigger house. Multiple people benefit from you spending more money on a more expensive, nicer home:
- Real estate agent earns more commission
- Bank earns more interest
- Friends & family enjoy more ammenities (ie: neighborhood pool, community golf course)
It’s not just outside pressure, the demands can come from inside your family as well. Your spouse or kids might be lobbying you to buy a house that you know your family can’t afford. Or maybe you found a house that has features you’ve always wanted and you’re really tempted to go after it, even though it would stretch your budget. Just know that the pressure will be there and the smart thing to do is to ignore it.
How Much Should You Spend On a House?
The last few years in the real estate market have shown us what can happen when people buy more house than they can afford. As we’ve covered above, here are some key points to helping you avoid ending up with a mortgage that’s too big for you:
- Borrow What You Can Actually Cover, Not What the Bank Thinks You Can
- Know Your Life Plans so You Don’t Mortgage Your Future
- Leave a Buffer so You’re Not House Poor
- Avoid Pressure, Combat it With Logic
If you find a house you want to buy figure out your total costs; this means closing costs as well as the ongoing costs of principal & interest payments, taxes, insurance, and home maintenance. Run those costs against the checklist above to see if the amount you want to borrow makes sense today, tomorrow, and 10 years from now.
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