If the last few years have taught us anything, it's this: Never buy more house than you can afford.
During the real estate boom, many agents and lenders were only too willing to help prospective homeowners find creative ways to finance homes that were beyond their means.
Too often, eager buyers went along. Today, millions of those owners have lost their homes. The real estate crash was a tough lesson in the importance of responsible financial planning when buying a house — the largest purchase most of us will ever make.
Wise home-buying begins with figuring out how much you can spend on housing and how much you should put into a down payment, then sticking with your plan despite the temptation to think “just a little bigger.”
It’s not hard.
Follow these 5 smart moves, and you’ll be in great shape to buy a house that fits your budget.
Smart move 1. Spend 28% or less of gross income.
For many years, a rough benchmark has prevailed when it comes to figuring out how much home a prospective buyer can afford. It’s called the “28/36 rule.”
The first half works like this: Your monthly housing costs, which include mortgage, insurance, property taxes and condo or association fees, shouldn't exceed 28% of your monthly gross income.
Add together all your sources of income — salaries, business income, anything else — before taxes, then multiply by 0.28 and you’ll have a good idea of where your housing costs should land.
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Some experts say spending less is even better.
Liz Weston, author of The 10 Commandments of Money, recommends keeping your housing costs down to 25% or less of your income.
Lenders also have grown more cautious since the housing bubble collapsed, and a few are now requiring that housing costs be kept as low as 21%.
If a lender's requirements strike you as too restrictive, shop around. Just don’t get carried away. Leaving yourself house-poor is a sure way to take the joy out of a new home.
Smart move 2. Hold your overall debt payment to 36% of income.
This is the second half of the rule. Your total monthly debt payments shouldn't exceed 36% of your gross income.
In other words, your mortgage, credit card bills, car and student loans, and other debts shouldn't break this barrier. To find out the amount, take your income and multiply by 0.36.
If you’re carrying more debt, you’re going to be able to purchase less home. For example, if you have a monthly income of $5,000 and no other debts, you should be able to swing a home payment of $1,400 (5,000 x 0.28).
But if you have another $600 in other monthly loan bills, that amounts to 12% of your income. This means you’re only going to be able to spend 24% (36 minus 12) of that income on housing, which comes out to $1,200.
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It's easy to put these rules to work. Just enter your income and nonmortgage debt payments into our mortgage calculator, and we'll tell you how big of a loan and monthly payment you can reasonably handle.
Here’s a tip. If other debts are crimping your housing plans, take a year or two before buying a home and focus on clearing off some of those credit card or student loan bills. You'll be way ahead in the long run.
Smart Move 3. Determine how much you can put into a down payment.
The amount you can put down plays a big role in how much you can pay for your house.
Many lenders are requiring larger down payments than in the easy-money days of the past.
The average down payment for conventional, 30-year, fixed-rate loans used to purchase a home has held right at 21% to 22% for more than a year now, according to Ellie Mae Inc., a California-based mortgage technology firm whose software is used by many lenders.
Jim Merrill of Axel Mortgage Inc. in Phoenix says requirements have been loosening recently, with lenders willing to consider lower down payments for borrowers with excellent credit.
Still, the down payment can be a heavy burden for many buyers. One alternative is a government-backed FHA loan, which requires down payments of as little as 3.5%, or a VA loan, which can require no down payment at all.
But the more you can put into a down payment, the more house you’re going to be able to buy or the lower your monthly payments.
Ideally, the money you use should be savings you've set aside for a home. If you don’t have the cash on hand, however, you might have another option.
Smart move 4. Chose wisely if you tap retirement accounts for a down payment.
If you don’t have the up-front cash you need, an Individual Retirement Account (IRA) or 401(k) may be the only place you can turn for the money.
If that's the case, tap a Roth IRA or Roth 401(k) plan first.
Since contributions to Roth plans are fully taxed before they're made, you can withdraw what you've put into those accounts at any time without incurring penalties or additional taxes.
If you've held a Roth IRA for at least five years, you can withdraw an additional $10,000 in earnings without paying any penalties or taxes to buy or renovate a first home.
The next place to turn is a traditional IRA, which will allow you to withdraw up to $10,000 for the purchase of a first home without penalty. (If you have individual accounts, you and your spouse could take a total of $20,000.)
But since contributions to these accounts are tax-deductible, you'll have to pay income tax on withdrawals and a 10% penalty above the $10,000 limit until you reach age 59½.
Your employer's traditional 401(k) plan is the last place you should turn for a down payment. Such "hardship withdrawals" are fully taxed and incur a 10% penalty until age 59½.
The better option is taking out a loan against your 401(k). You can usually borrow up to $50,000 or half the value of the account, whichever is less. Your employer can give you up to 15 years to repay the loan, if it’s for a home purchase.
Monthly payments are deducted from your paycheck. The interest you pay, generally a couple of percentage points above the prime rate, goes into your retirement account.
But now you're talking about a new loan payment that will reduce the amount you can borrow for a home. You’ll need to go back to Smart Move 2 and recalculate.
Homes are truly affordable in only about half of the nation's largest cities. Our new study found that buying a house is still a pricey proposition in many places, despite the big drop in prices and record-low mortgage rates. We grade the top 25 cities in our Fall 2012 Home Affordablity Study, and a couple of popular West Coast towns get slapped with an "F." Did your town pass the test?
Smart move 5. Take into account the overall cost of moving into a new home.
Buying a house comes with a big after-purchase temptation. You want to make it as nice as possible. It's easy to go a little crazy on new furniture and decorations.
When you’re applying for a mortgage, you’ll find your personal finances carefully scrutinized. But once you've bought a house, it's up to you to maintain discipline. It can be easy to run up your credit cards buying new stuff.
If you do so, you’re putting yourself in the same hole you did all your original planning to avoid.
Even if you remain frugal, you’re going to end up buying a few things, drapes or pieces of furniture, once you settle in. If you’re planning to do some remodeling, you’ll be spending even more. Try to take these costs into account from the beginning.
You’ll also want to hang on to some cash for an emergency fund, and Weston recommends budgeting 1% to 3% of the cost of your home for annual repairs and maintenance.
Yes, this is hard when you’re buying a house. But you never know when disaster might strike, and that mortgage payment will be easier to make when it does if you've left yourself a cushion.