The affordability test
It’s no surprise that Kate and Will (not their real names) are pinching pennies like this. With the median home price in the U.S. now over $230,000, a home is probably the costliest thing that they, or you, will ever spend money on. The important thing to focus on, however, isn’t whether a home is expensive; it’s whether it’s affordable — to you.
How do you judge affordability for a purchase that will likely require a down payment in the thousands or tens of thousands of dollars, plus a mortgage that’s designed to be paid back over 30 years?
Start with your income, financial professionals say.
One quick way to estimate how much of a monthly payment you can afford is to divide your annual gross income by 12 — and multiply the result by 0.28, says Cary Carbonaro, managing director at United Capital and author of the book, The Money Queen’s Guide.
The dollar amount you end up with is the most you should consider spending on monthly housing costs: your mortgage payment (principal and interest combined), property taxes, and insurance. So, for example, if you had $72,000 in annual income, you’d take 1/12 of that, or $6,000, and multiply that by 0.28 to arrive at a maximum monthly fixed housing costs of about $1,680. That amount, equal to 28% of your average monthly gross income, is “a great rule of thumb,” Carbonaro says.
To ballpark your possible housing costs you can use one of the many mortgage calculators on the internet; a good one is Zillow’sOpens in a new window, which makes it easy to see the impact of property taxes and insurance on the affordability of a particular purchase.
While the 28% formula is a useful guideline — one that will probably help determine how much a bank is willing to lend you - keep in mind that a bank might be willing to lend you more than you can comfortably afford to pay, says Jude Boudreaux, founder of Upperline Financial Planning in New Orleans.
In part, that’s because those monthly payments are only part of the cost of owning a home. You’ll also have to pay for utilities, such as water and electric, and any repairs that pop up, like a broken air conditioner or a leaky roof. As Boudreaux puts it, “You always want to have some cash available to take care of the relatively predictable but unpredictable things that happen when you own a home.”
So you have to take a good, hard look at your cash flow, which Boudreaux divides into three different elements: money that you’ve already committed to paying, such as a car loan or student debt; money you need to cover your day-to-day expenses, such as food, transportation, clothing, phone service and entertainment; and money you’re saving for future needs, such as retirement.
Any mortgage payment will have to come out of your current spending or savings for the future, so set your sights on a home that you’ll enjoy but won’t cost so much that, as Boudreaux puts it, “you can’t enjoy anything else in your life.”
Putting money down
Before those monthly costs hit your bank account, though, you’ll have to come up with a down payment. How much will you need for that? With a Federal Home Administration (FHA) loan, you can buy a house putting down as little as 3.5% of a home’s cost upfront. But financial professionals suggest saving up for a 20% down payment.
The smaller your down payment, the higher your monthly mortgage bill — and the more interest you’ll pay over the life of your loan.
One reason, says Boudreaux, is that if you can save up that amount, it’s a good sign that you’ll be able to manage your household cash flow in the years ahead, when you’ll have the added financial pressures of owning a house.
Another reason is that if the down payment is smaller than 20%, you’ll have to pay what’s known as mortgage insurance, which protects the lender financially if you default on your home loan. That insurance can add up. If, for example, you put 3.5% down and got an FHA loan to buy a starter home priced at $116,000 (about half the current cost of a median-priced single-family home in the U.S.), on top of a regular mortgage payment of at least $500, you’d pay about $100 in insurance premiums every month.