Debt Free

How expensive of a home to buy is one of the first questions to ask yourself when you begins house shopping. Depending upon who you ask, there are two different answers to this question, although the answer may not be as different as it would have been last year. The two answers will come from your lender and good ole’ common sense. In the past it was common for lenders to allow many borrowers, especially those with better credit scores, to take on a bit more mortgage debt than many analysts would consider prudent. Viola! Instant credit crisis!

When I bought my home some years back for instance, my lender informed me that I could afford a home that cost $235,000. At the time, my wife and I thought the better of buying such an expensive house and settled for one that cost $152,000, although we looked at homes that cost up to $195,000. We actually made offers that were up to $189,000. In retrospect, it turned out to be a great decision to avoid a home in the $200,000 plus price range. After having kids the extra cash every month was definitely welcome. Some of the homes in the upper $180,000s would have been nice though, and we would have made up some of the difference in the lower maintenance costs associated with a newer home.

How do you answer the question of how expensive a home to buy? Many experts recommend buying a home that costs no more than 3 times your annual income if you’re putting 20% down. Needless to say (but I will anyway) a 20% down payment can be a stretch for a first time homebuyer, especially in some of the more expensive metro areas throughout the country. The 3 times the annual income isn’t a hard and fast home pricing rule, and can be altered by your expected annual income increase and your debt level.

If you are carrying very little debt or are in a career where you reasonably expect to receiver rapidly growing compensation, you may decide it is worth it to take on a higher priced home. I tend to break on the conservative side of this however, and many homeowners that find themselves in trouble today got that way due to buying a home that was too expensive. When the expected income gains failed to materialize, they couldn’t refinance, or they had an unexpected major expense, their mortgage payments were difficult or impossible to maintain. 

Be a bit conservative when deciding how much home you can afford. Take into account your current, and perhaps more important, your expected future level of debt. If your debt level is greater than 10% of your annual income, ratchet back your expectations a bit and buy a slightly less expensive house, in the range of 2.5 times your annual income.

Also consider the local real estate market, current mortgage interest rates, and your family plans. If you plan on having a large family, for example, it might be better to buy a smaller, lower priced home now. Later you can use your equity to get into a larger home, when you really need the space and your career is more advanced. If mortgage interest rates are quite low, as they are now (5.74% for a 30-year fixed, as I write this) you’ll be able to afford slightly more house, but you’ll also want to take more advantage of the relatively inexpensive money. This increases your ROI as the value of your home appreciates.

Your new home price should not be the total of the largest loan you can qualify for and every last penny worth of cash you have to your name. It’s a difficult decision, because the family home is the best investment for many families, and one of the only ways that many people generate any real wealth. However, if your employer offers a retirement plan with matching contribution, you may be better served to go a bit more conservative on the house and put the remainder into your retirement plan. This will allow you to take advantage of your employer’s matching and leave your less likely to run into problems down the road in the event of an unforeseen financial difficulty.