How much house can you afford?
The housing market has taken off again.
Home prices are climbing fast and closing in on the record highs we saw just before the housing bubble burst.
Bidding wars for desirable homes are common in many cities, putting incredible pressure on buyers to spend more.
Yet the fundamentals of wise home buying never change.
It's all about figuring out what you can afford — based on how much you can reasonably borrow and the amount you have for a down payment — and then sticking to that budget.
Follow these 5 smart moves, and you'll know exactly what you should spend on a place to live and not wind up house poor with a bad case of buyer's remorse.
Smart move 1. Determine how much you can afford to borrow.
For many years, home buyers seeking a mortgage have been well-served by what's called the 28/36 rule.
Maximum housing costs
We calculated how the 28% rule works out for various incomes. If you have one of the incomes below, here's the maximum you should spend.
|Annual income||Monthly housing limit|
It says your total:
- Monthly housing costs, which include mortgage payments, insurance, property taxes and condo or association fees, shouldn't exceed 28% of your monthly gross income.
- Monthly debt payments, including credit card bills and student loans, shouldn't exceed 36% of your gross income.
It's easy to put these guidelines to work.
Just enter your monthly income, bills and projected housing costs into our mortgage calculator, and it determines exactly how much you can afford to borrow and the monthly mortgage payment you can reasonably handle.
A key factor the calculator needs to know is how much your mortgage will cost.
Home loans remain a bargain, historically speaking.
The average cost of a 30-year fixed-rate mortgage — the most popular way to finance a home — is just above 4%. That's still a relative bargain.
How debt limits what you can afford
|Annual income||Monthly debts||Monthly housing limit|
And remember, it's the average cost of financing a home. Savvy borrowers with decent credit can almost always pay a quarter to a half point less.
Spend a few minutes searching our extensive database for the best current mortgage rates from dozens of lenders in your area to get a good idea of what you can expect to be charged.
Any online real estate listing for the size and type of home you hope to buy can provide property tax and insurance costs you'll need to get the most accurate estimate of how much you can afford to borrow.
Smart move 2. Add up how much you have for a down payment.
The bigger the down payment, the bigger the house you can afford to buy.
For most buyers, the down payment comes from two sources — savings and the equity they've built up in their current residence. (Equity is the current market value of a home minus the outstanding balance of all mortgages.)
But borrowers can qualify for conventional mortgages with down payments of 3% and credit scores as low as 640, according to Jim Merrill, founder of Axel Mortgage Inc. in Phoenix.
Different options also are available for paying mortgage insurance premiums, which have come down, and many lenders will now let you use a monetary gift for a down payment. A good mortgage broker can run you through the possibilities.
"I'm getting loans approved today that would not have been approved just a few years ago," Merrill says.
If you’re struggling to qualify for a conventional loan, another option 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.
Smart move 3. Choose wisely if you tap retirement accounts for a down payment.
Taking money out of retirement plans for a down payment is not ideal.
But we know that many families have most, if not all, of their savings tied up in individual retirement accounts (IRAs) or 401(k) accounts where they work.
If that's the case, tap a Roth IRA or Roth 401(k) plan first.
Because 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 to buy or renovate a first home without paying any penalties or taxes.
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 of 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.
Smart move 4. Calculate an affordable purchase price.
Add how much you have for a down payment (from Smart moves 3 and 4) to the maximum amount you should borrow (from Smart move 1), and that's the amount you can afford to spend on a house.
Don't hesitate to revise this estimate as you shop for houses and mortgages.
Has a fixer-upper popped up on your wish list? If so, you probably need to reduce the size of your down payment to have more cash available for renovations.
Do the homes you're looking at have lower property tax bills, or higher association fees, than you expected? Have you found the perfect lender offering a lower interest rate?
Go back to the mortgage calculator, and revise your borrowing power.
Smart move 5. Know your local housing market and plan accordingly.
It's a sellers' market across most of the country again, creating lots of pressure to commit more than 28% of your income to housing.
"Buyers are coming back in force,” says Lawrence Yun, chief economist for the National Association of Realtors, yet relatively few homes are for sale.
Everything, from a lag in new construction to a dwindling number of foreclosures to the reluctance of homeowners who refinanced into uber-cheap mortgages to sell, has contributed to this shortfall.
That imbalance in supply and demand is pushing property values up about 8% a year nationwide and has boosted the median national home price to $234,000, beyond its all-time high of $230,000 reached in July 2006, according to a report from the National Association of Realtors.
Many cities, from Denver and Dallas in the heartland to San Francisco and Washington on the coasts, are experiencing double-digit price increases that have already sent housing costs soaring past pre-recession records.
Three out of every five homes in the 50 largest markets are getting multiple offers, according to real estate broker Redfin, with one of every six homes selling for more than the original asking price.
If you live in a housing market like that, you need to take this into account.
Let's say you can buy a house for $250,000, but you determine that desirable homes in your area have started going for about 5% above the asking price.
That means you need to adjust the price of the homes — at least the best ones — you're looking for down by about $12,500 (5% of your actual budget).
If you absolutely must spend more than these calculations say you can afford, figure out how much more you're committing and go into the purchase with your eyes wide open.
Should all of the extra money have to come from a bigger mortgage, you can probably cope with spending an additional 10% without too much pain or inconvenience.
But once you get up to 20% or 25% more, you'll have to make significant changes in other parts of your life, such as suspending contributions to retirement plans and college funds for your kids.
The cash you need to furnish your new house, replace aging cars and take vacations may also be gobbled up by your mortgage payments.
You'll know what it means to be house poor, and that's what we're trying to avoid.