Debt Free

“How much house can I afford?” is one of the most important questions you need to be asking if you're shopping for a house. Getting the wrong answer about how much house you can afford is a sure way to end up in the unenviable position of house poverty, where your house owns you, rather than the other way around. Too many people got the answer to this question wrong in the past decade, leading to the rash of foreclosures we're experiencing today. Here's how to find out how much you can afford, or maybe even more important, how much you should spend on your next house.

There are a few things to consider when you're calculating the affordability of a house. The first obviously is your income. How much money you make, or more accurately how much you bring home, will go the greatest distance toward explaining how much you can afford. The next piece of the affordability puzzle is how much of a down payment you can afford to contribute to your purchase. The question of how much down payment you can contribute is actually separate form the question of how much you should contribute. Obviously the greater the down payment, the lower your monthly payment will be.

There are two schools of thought when it comes to a down payment on your house. The first states that you should put as much down as possible, while leaving enough in your emergency fund to cover 3 – 6 months of living expenses. This strategy will reduce your monthly mortgage payment maximize your initial equity. This is the more fiscally conservative position.

The second school of thought on the size of your down payment says that you should be able to generate higher returns on your money by investing it than the interest you're paying on your mortgage, especially when the tax consequences of the mortgage interest deduction are calculated. As an example, if your mortgage interest rate is 5.9%, you would be better served by minimizing your down payment and investing the rest, presumably at a higher rate of return. This can be an extremely powerful strategy to generate wealth.

To illustrate the differences between the two different down payment strategies, consider the following example:

If you were to purchase a $250,000 house (I'm leaving out other costs for ease of calculation) and put 20% down, it would cost you a down payment of $50,000. Your monthly mortgage payments would be approximately $1,186. If you put only 5% down, your down payment would be just $12,500, and your monthly payment would be $1,409.

If you invested the $223 difference in the payments every month and received a 9% ROI, you would have a nest egg of $397,588 at the end of your 30 year mortgage. If you took the difference in the down payments of $37,500 and invested it at the same 9% rate of return, you'd have $497,538. This ignores the tax advantages you'd also receive by using the smaller down payment. Because of the mortgage interest deduction, you would be able to deduct the interest on your mortgage from your income. In the first 15 years of your mortgage that generates a substantial tax savings. However, it also ignores the fact that you'd be paying less interest due to the fact that you financed a smaller amount of money, and that with the small down payment strategy you'll be wasting money on PMI until the LTV ratio is at 80%.

With the larger down payment you would pay approximately $228,000 in interest over the 30 year life of the mortgage. With the smaller down payment, you would pay about $270,000. In purely monetary terms you would come out ahead with the lower down payment strategy, and that is before the tax benefits are included in the calculation, which would swing the calculation even more in favor of the lower down payment strategy. The one big caveat here is that you actually have to invest that lump sum, generate a consistent return, and not withdraw the investment for the 30 years in order for the calculations to be valid. Keep in mind too that there are fewer lenders willing to give you a mortgage with only 5% down these days, while many more are happy to do so with 20% down.

So, once you decide how much of a down payment you are going to use, you can calculate how much house you can afford. One problem faced by borrowers today is that lending guidelines have been changed to the point where you can actually get a house that costs too much for your budget. This condition wasn't as prevalent in the past, although now the pendulum is swinging back the other way. Most lenders allow a figure of 36% of your total gross income be allocated for debt payments, including your mortgage. I'm more comfortable with approximately a 33% debt allocation figure.

Many financial experts suggest that you can calculate how much house you can afford using 25% of 25% your monthly income. That is very fiscally conservative and likely to keep you well within your means. The only problem is that in many metro areas of the US, you just can't get much house at that figure, and in some areas you'd have to have what some would call a really good job in order to buy a house.

For example, according to the NAR's median sales prices for single family homes data (Q1, 2008) the media sales price of a home in Atlanta, GA is $154,000. That pencils out pretty well. If you put 5% down, you payments would be $868 per month. Add some property taxes and you'd be at about $1050 per month. You would need a monthly net income of $4,200 to afford that median Atlanta house. Cities such as Houston, Memphis, Pittsburgh, and St. Louis are even more affordable. The problem with the 25% calculation comes into play in some of the more expensive housing markets in the country. If you live in San Francisco or the surrounding areas, you'll pay about $775,000 for the median house, requiring a monthly income of $17,460 to stay at the 25% level.

This illustrates a point. As your income rises, you can actually afford to spend proportionately more on a house, because your other expenses will not rise to the same extent. For example, if you live in the Bay Area, in the median house, you will probably not need $13,000 a month to cover the BMW payments and your dining expenses. It also illustrates why so few people starting out can afford to buy a house in the more expensive metro areas. I dare say that not too many of you jumped into the job market with offers of $209,520 annual salaries! Other cities where you probably can't afford to buy a home unless you already own one include San Diego (median house $459,000), Los Angeles ($459,000), Honolulu ($620,000), Boston ($357,000), Bridgeport, CT ($439,000), New York City ($445,000), Newark, NJ ($409,000), and Seattle ($372,000).

So, the question of how much home you can afford can be easily answered, but in many areas of the country, the answer is just “NO!”