How much house can you afford?
For the first time, my husband and I are house-hunting. Or rather, I am. My husband’s afraid to buy right now. He’s not sure where the economy is headed. I think he’s just afraid of commitment—after all, it took him two years to propose. And we’ve been saving for a down payment for years. We’re probably good, right?
—Miriam, St. Paul, Minn.
When I hear a question like this, I’m reminded of the scar that the Great Recession left on the economic psyche of this country. We’re all a little nervous that the next “big one” could be right around the corner—and it’s hard to know where to look for answers.
Economists disagree. As for the banks? Well, they’re not perfect either. After all, the people who ended up in foreclosure or with underwater mortgages in the wake of the Great Recession had found banks to make those loans. (Lending standards have tightened up since then, but it’s never a good idea to rely on regulations instead of your own common sense.)
The best way to avoid making the wrong decision about buying a house—or making any big financial commitment—is to do your homework, and to stay conservative, moneywise. You said you have been saving for a down payment, and that’s great. The next step should be figuring out what kind and how big of a mortgage you’ll need. Sure, there are ways to figure out how much you can get. But there’s how much a bank will loan you, and then there’s how much you can actually afford as a first-time home buyer.
Here’s how to figure out the latter:
You’ll want to get a ballpark figure for your mortgage loan before you start looking at houses. Before they’ll even show you a house, some real estate agents require proof that you’ve talked to a lender. There are two ways to do this: You can get prequalified, or you can get preapproved.
Prequalification is the less rigorous process, but it also carries less weight with an agent (and potentially, a seller). You simply provide info like your income and expenses to a lender, and they estimate how big a mortgage you are likely to qualify for when you apply. These days, though, this won’t give you an edge when you’re making an offer on a house.
The gold standard is preapproval, which requires you to provide documentation, like pay stubs, bank statements, and tax returns. A lender will also pull your credit score. Then they’ll tell you the upper limit of the loan you’ll be approved for.
You’re not required to use a lender who preapproves you when you actually obtain your mortgage, and I encourage you to comparison-shop at three different lenders once you have an accepted offer on a house. One thing to keep in mind: Preapprovals are generally good for only 60 to 90 days.
Put the numbers in perspective
The purpose of this process, from the point of view of lenders and sellers, is to know how big a mortgage you can swing. Generally, they want to see you spending no more than 28% of your take-home pay on housing expenses—mortgage, property taxes, and insurance—and no more than 36% of your gross income on debt—like credit cards and student loans.
But just because you qualify for a certain number, that doesn’t mean you should take it. You may be tempted to get a mortgage right up to the penny of the prequalified figure. That’s probably not the smartest financial move.
Say you make $80,000 a year ($6,600 a month), spend $300 a month on a car payment and $200 a month on student loans, and pay a minimum of $25 a month on each of two credit cards. Should you really buy a house for $315,000? Some prequalification calculators may suggest it’s within your means. With a good credit score and an interest rate of 4.5%, your monthly mortgage payment will be between $1,500 and $1,600 a month, including taxes and insurance.
But that’s assuming you scraped together the $63,000 for a full 20% down payment. (Even after the fallout from the real estate–driven Great Recession, the average down payment these days is still closer to 10%.) And then, of course, there are the expenses that go along with owning a home (expenses that renters leave to landlords), such as home repairs and improvements, utilities, pest control, replacing appliances, and on and on.
Think about your financial goals…then do your own math
Take a look at your monthly take-home pay. Subtract all your known expenses, including the mortgage (plus taxes and insurance) you’re planning on. Now think about whether you can live on the rest—and still save for retirement and your personal goals (an optimal overall savings target is 15% of take-home pay, though that can seem wildly unrealistic when you’re a prospective home buyer), while paying down any debt. Odds are, you’ll see that the number the bank gave you is too high.
It’s impossible to see into the future. You can’t predict whether you or your spouse will lose a job. You might suffer a health crisis or face another big economic recession. If you stretch yourself too thin to buy a house—even if the bank says you can afford it—any event like this could push you to the financial breaking point.
If you keep your house budget modest, you may not end up with every crown moulding and Jacuzzi bath you wanted, but you will sleep better at night. And that’s worth much more than square footage. I promise.