Buying a home is one of the biggest financial commitments most people make in their lives. It can be a wonderful experience filled with joy as you turn the key in the front door of a property that you can call your home.
When we research an area in which we wish to buy, we check what the median house prices are in the area and also find out how much we could borrow for a loan by plugging our details into an online calculator. The next step is to usually make an appointment with a bank and talk to them about pre-approval for a home loan.
What the banks tell you
You give the bank all of your details such as gross income, monthly debt repayments, everyday expenses, and they'll give you a top end number that you could be approved for. This isn't the guaranteed amount. It's just an estimate. What I've found is that the bank approval value is usually higher than most of the online calculators these days and it's easy to get tricked into thinking you can afford more just because the bank says you can.
So the banks will loan me something I can't afford? No, not necessarily. But banks do prefer you to take out as high a loan as possible, that way they make more money from you. 10% interest on a $400,000 loan is more than 10% interest on a $100,000 loan. Obviously they still want you to be able to pay your loan, otherwise you'd default and the bank is left to foot the bill.
The main thing the banks care about is that you make enough money to be able to pay the bill each month, even if that means you have to neglect things such as housing repairs or saving for retirement to do it. That's why it's important to factor in all those personal finance items into the equation to see how much mortgage you can afford.
How much mortgage can I afford?
All too often we find the "perfect" home that we must have, and we financially overstretch and commit ourselves to paying for something that we struggle to afford. Besides, the bank told us we could afford that much so it shouldn't be so hard.
A few factors should be taken into consideration when trying to figure out how much you could afford to pay each month, such as:
Household income
Monthly debts (student loans, car loans, etc.)
Amounts deducted for retirement savings
Your credit score (will dictate the interest rate you get)
Available amount for a down payment (the more you have the less the loan will be)
A good rule of thumb is for your housing expenses not to exceed 28% of your gross income. For example let's say Joan earns $70,000 a year, that's $5,833 each month. $5,833 x 28% = $1,633. For Joan, mortgage, taxes and insurance shouldn't cost her more that $1,633 a month if we follow this logic. You should also aim to keep your total debt to under 36% of your gross income.
I personally like to base the calculations off of net income, as it's a more realistic and tangible number. Obviously if you do it this way your "how much can I afford" number will be lower as a result.
The true cost of owning a home
The mortgage cost is only one piece of the puzzle. Owning a home comes with a whole new set of expenses you may not have been used to with renting or living at home. We also have to factor in closing costs, insurance, property taxes, furniture and maintenance.
Closing costs: On average, closing costs are about 2-5% of the purchase price. This is a lump sum you will have to pay on top of the purchase price. You need to factor this in when buying a home.
Insurance: Insurance premiums will vary greatly depending on the size of your home, where you live, how old the house is, and more. Depending on what type of cover you opt for, this could be in excess of $1000 a year, which will need to be factored into your monthly budget.
Property taxes: Here's another one you can't get away from. This is based on the value of your home. The more expensive your house, the more you'll pay in property taxes. Ugh! This could be a few thousand a year or more.
Furniture: If you're moving from a rental property into your new house this might not be so bad. If you're starting from scratch this could be a huge expense. Purchasing items like a fridge, washer, dryer, couches, TVs, beds, dining table, and cooking appliances could total $20,000 or more! It's a good idea to factor in enough to cover this additional expense, although this will vary by individual.
Maintenance: A lot of people shrug this one off with the attitude of "not needing to budget for repairs" on a new-ish house. This is a big mistake. You should factor in at least 0.5-1% of the property value for maintenance each year. So that would be $1,500-$3,000 for a $300,000 house. Now you likely won't pay that each year, but you might have a big expense or a remodel every 10 years which would gobble up that amount and then some!
Put it all together with real numbers
Factoring in all the additional monthly repayments with the mortgage repayments, we get a much higher total monthly payment we need to budget for. This total amount is what we need to factor into our budget, not just the mortgage value.
Conclusion
Buying a home you can truly afford while still having enough money left over to live your life and achieve your financial goals will take a bit of mathematics to figure out. By keeping your housing expenses to less than 28% of your gross income and your total debt to under 36%, you'll ensure you don't "drown in debt" and always stay broke.
Be sure to factor in all expenses that come with owning a home and add these to the mortgage total to get an idea of how much it will truly cost you. If it tallies out to be over 28% of your gross income, you might want to consider looking for a smaller property or save more for the down payment to bring the total within your budget.
Don't overstretch for a house you think you "need" or because you think "it'll be a good investment" (a home you live in is not an investment). Do the sums and make sure it will fit your financial situation.
Blake - FIRE with a family