When you’re thinking about buying a home, how much you can afford is a critical question to answer. And it turns out there can be more than one answer to it. The number can change significantly depending on how you define afford. The question potential home buyers should focus on is: How much home can I comfortably afford?
You Can Uncomfortably Afford More
There are lending ratios that are used in the mortgage approval process, but those are really to see if you can afford to repay the loan, comfortably or uncomfortably. When it comes to mortgages, the numbers and formulas don’t factor in your being comfortable, just whether or not you’re at a high enough risk of actually defaulting on the loan. The ratios don’t care if you’re not able to save for retirement, take vacations, or even set money aside for future home maintenance.
The difference between what a lender determines you can afford and what you can actually afford can be quite large. Affordability is rarely a yes or no proposition. It’s a spectrum, and between comfortably affording and not affording something is uncomfortably affording it. It’s a place where you can make the payments, but they are a burden because you cannot afford other important things.
Know What You Can Comfortably Afford
So if lending ratios only solve for what you can uncomfortably afford, how do you figure out what you can comfortably afford? This is answered with a spending plan, one that’s not just based on typical monthly spending but also averages in everything else. By doing so you are accounting for future home maintenance spending and other non typical expenses. Your spending plan can make sure vacations and other lifestyle expenses are covered by your income, in addition to what is allocated to housing.
Include All Housing Expenses
While a mortgage payment is a big part a homeowner’s expenses, so are property taxes, insurance, and maintenance. In some cases, taxes and insurance may be escrowed by the mortgage company and part of the monthly payment, but building up savings for home maintenance is left to the homeowner. Maintaining a home is expensive, and you can’t wait until you need to replace your roof to start saving for it. Maintenance costs can average out to between 1% and 3% of the value of a home on an annual basis. And don’t forget to count any homeowner association fees.
At 1%-3%, that means annual maintenance on a $300,000 home could average $3,000 to $9,000 per year, or $250 to $750 a month, that cannot be spent on other things. And after you’ve spending plan you can apply a couple of other guidelines to keep your finances in check. These are all guidelines, not rules. They are tests to keep you reasonably close to a mostly unpredictable future. Individual circumstances may justify to higher or lower amounts.
The 25% Guideline
Aim to keep your total housing expense to 25% or less than your available, after-tax income. Total housing expenses include mortgage, taxes, insurance, and maintenance. 25% may sound low when compared with lending ratios that are based on gross income and do not include maintenance costs, but it’s more reasonable in the context of all your other spending. If you want to keep spending obligations to 50% of your income like with a 20-50-30 budget, than housing is half of your obligated expenses at 25%. There still needs to be room for utilities and other monthly services, transportation, and other necessary expenditures.
The ⅓ Guideline
A second test, independent of income, looks at liquidity and whether you have enough cash to purchase a home without taking undue risks. You want to have enough cash on hand to equal at least ⅓ of the home’s purchase price. If you do, you should have enough for a 20% down payment, closing costs, moving expenses, and move-in incidentals. The remainder should be pretty close to a good size emergency fund for a new homeowner with a mortgage.
You can buy a home with much less available cash, and you can spend a greater portion of income each month to pay for it. But just because you can, doesn’t mean it would be wise to do it. Owning a home should be about comfort and security.
Do you have an action plan preparing you for home ownership? Do you know how much you can comfortably afford to spend on a home? Financial coaching may help you with your home purchase plans.