How much house can you afford?
After five bleak years, the housing market is heating up again.
Banks are once again loosening mortgage requirements, accepting lower credit scores and writing home loans with as little as 5% down. Prices are up and current mortgage rates have inched higher.
The temptation is to jump in before prices climb higher and buy as much house as you can qualify for.
After all, home values are increasing, right?
But this is when you really need to be smart about buying a home — the largest purchase most of us will ever make.
The real estate crash of 2007, which cost millions of Americans their homes, should have provided an unforgettable lesson in the danger of buying more home than you can really afford.
Wise home-buying is about figuring out what you can afford, how much you can put into a down payment, and then sticking to your plan.
It doesn’t have to be 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.
Maximum housing costs
We calculated how the 28% rule works out for various incomes. If you have one of the below incomes, here's the maximum you should spend.
|Annual income||Monthly housing limit|
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.
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.
How debt limits what you can afford
|Annual income||Monthly debts||Monthly housing limit|
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, focus on clearing off some of those credit card or student loan bills before you buy a home. 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.
Jim Merrill of Axel Mortgage Inc. in Phoenix says requirements have loosened significantly since the height of the recession, when lenders were demanding 20% down and excellent credit.
"Conventional loans are now available with as little as 5% down with a (credit) score as low as 620," Merill says. "For borrowers with great credit, the entire 5% down plus closing costs can come as a gift."
But remember, 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. Choose 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.
The American dream of home ownership slipped out of reach for more families last year as housing affordability fell in all major cities, according to an Interest.com study. Our second annual Home Affordability Study found that rising home prices and mortgage rates outstripped modest increases in family income in each of the 25 largest metropolitan areas. Prices have risen so much that a median-priced home was affordable for a family earning a median income in only eight of those cities, compared with 14 a year earlier.
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.