How much house can you afford?
Despite some signs the economy is cooling off, the housing market remains strong across most of the country.
For the first quarter of 2016, home prices continued to climb in 87 percent of metropolitan markets, according to the National Realtors Association.
House prices in most markets have now recovered most or all of the value they lost when the housing bubble burst in 2008.
That means bidding wars for desirable homes have become common again, putting pressure on buyers to spend more.
It also means now is the time to take a step back: 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 around 3.75%. That's still a 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.
An 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 an 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 what you still owe on 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.
And options are available for lender-paid or discounted mortgage insurance, including programs from Fannie Mae and Freddie Mac, the government-created lending institutions, that also will 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 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 seller's market across most of the country again, creating lots of pressure to commit more than 28% of your income to housing.
Solid job growth over the last several years combined with low mortgages have "spurred steady demand for home purchases in many local markets," says Lawrence Yun, chief economist for the National Association of Realtors.
Yet the number of homes for sale hasn't kept up with demand. The imbalance in supply and demand pushed property values up about 6.3% in the first quarter of 2016 compared with a year ago. The median national home price was $217,600.
Prices jumped the most in the Northeast and Florida, averaging double-digit increases in both.
Nationally, three out of every five homes that national real estate broker Redfin handles are getting multiple offers, it reports, and slightly less than a quarter are selling for more than the original asking price.
But in many high-demand markets, such as Denver or Seattle, well over half of homes are going for more than their original price. If you live in a 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, or giving up vacations or other big ticket items.
You'll know what it means to be house-poor, and that's what we're trying to avoid.