Written by: Corey Janoff
This blog post was originally published on our previous blog website on May 23, 2017. It has since been revised and updated.
One of the most common questions we get asked by clients is, "How much house can I afford? Today we will look into how much house you can afford to purchase. We receive many questions about buying homes, especially from our physician clients, as they transition out of training and into practice, seeing their incomes shoot up 300-400% (or more!) overnight. So, let's dive into it!
Home Down Payment
First things first, we need to have a down payment of some sort for the house. Even if you qualify for a special financing program, like a VA loan, or even some physician mortgage loans that require 0-5% down, you will still need some money for closing costs ($10,000 give or take). The lender will also require you to have typically 4-6 months of reserves available after the down payment, and closing costs are accounted for (could vary by lender and property type/cost). They don't let you liquidate your entire savings to use for the down payment.
For example, if you are financing $400,000 and your monthly mortgage + tax/insurance payments are $2,500, you will probably need $20,000 at a minimum in savings to cover closing costs plus four months of mortgage payments.
Under non-COVID times, you will likely need at least 5-10% of the purchase price for a down payment unless you qualify for a special financing program. Right now, many lenders require a larger down payment due to uncertainties surrounding the economic ramifications of COVID. While avoiding a down payment has its advantages, if you can't afford to save up the 5% needed for a down payment, then that is a good sign that you probably can't afford that house. Sorry.
If you can afford to put 20% down, you will have the most available options from a property selection and financing standpoint. Some lenders require 20% down for certain types of properties (this is common with condos).
If you have family willing to gift you or lend you the money for a down payment, that is fantastic! However, depending on your funds' source and how they're transferred, it could cause problems when getting approved for financing. It's important to work with your lender as early as possible to discuss ways in which borrowed or gifted funds can be used for the home purchase.
Home Purchase Price
This is the one number that everyone wants to know. What is the maximum amount of house I can purchase a house without breaking the bank? This is the number we use to filter our home searches on Redfin and Zillow. This is the number we give our real estate agent to find homes that fall under that range.
Pro tip: give your real estate agent a price range below your actual maximum because they will likely show you some houses that are a tad out of your price range, and there's a good chance you'll like those best. They are trained in the art of selling!
The amount a mortgage company will approve you for and the price you should stay within are two different things. A mortgage company simply looks at your income and current debt obligations and then runs a basic math formula to tell you how much loan you can qualify for.
The problem with this number is it doesn't consider all of your other expenses and goals in life. If you have three kids, daycare costs, student loans, and help your parents, your monthly expenses are probably a lot higher than someone who doesn't have any kids or student loans. Suppose you like to travel the world and eat at excellent restaurants. In that case, the amount of money needed to live the lifestyle you want to live is probably greater than someone who is perfectly content relaxing at home with a good book they picked up for free at the library.
Those who argue you should maximize the amount you spend on a home because your home is your biggest investment and real estate always goes up in value, I disagree. Your home is your biggest expense, and real estate doesn't always go up in value. Read Is My Primary Residence an Investment? to learn more.
It is essential to narrow your home search to homes that fit within the price range the bank says you can afford and take a close look at your expenses to see how much you can actually afford each month. Which brings us to the real number people need to look at when purchasing a home.
Monthly Housing Cost
How much will this home cost me per month? As a rule of thumb in today's low-interest-rate environment, for a 30-year fixed-rate loan, you can expect to pay around $50/month on the mortgage for every $10,000 financed (maybe a bit less at the time this is published in September 2020 as mortgage rates are at historic lows). This does not include property taxes, insurance, homeowner's association (HOA) dues, utilities, maintenance, etc. So, if you finance $100,000, you can expect the mortgage portion to cost around $500/month. If you finance $500,000, you can expect the mortgage portion to cost about $2,500/month.
Don't forget to factor in an additional amount for homeowner's insurance ($50-100/month) and property taxes (varies by city/county, but 1.5% of the value is a reasonable ballpark number to estimate going in). Also, plan for any other possible payments associated with the home, if applicable (HOA's, private mortgage insurance).
There are plenty of simple online calculators that you can use to see how much the monthly payment will be. You can play around with the variables like the interest rate, loan length, down payment amount, etc. and see how that affects the monthly cost.
Look at your current expenses; food, groceries, personal supplies, cell phone, cable, internet, water, sewer, garbage, electricity, gas, car payments, transportation costs, childcare, student loan payments, charitable giving, shopping, gifts, fun money, travel, gym, housekeeper, landscaper, and other miscellaneous expenses. Be sure to include a buffer for random stuff that goes wrong from time to time and costs money.
Also, don't forget to factor in retirement savings and college savings for children (if that is a goal of yours). Every individual is different, but a useful guideline is to invest 20% of gross income for retirement purposes if you want to retire at a reasonable age and have an enjoyable retirement.
Let's look at two scenarios below of people with the same annual household income of $150,000, but different lifestyles and expenses. Person number one lives a comfortable lifestyle invests 20% of his gross income for retirement and doesn't have childcare expenses or student loans. Person #2 has student loans and childcare expenses, lives a lifestyle with a little more fun and travel in it, but only invests 8% of his income for retirement.
As you can see from the above table, Person #1 can afford to spend a little over $2,500 per month on housing without making any lifestyle changes. This is the equivalent of a 30-year mortgage of approximately $400,000, with taxes, insurance, etc. included. Person #2 can afford to spend about $1,250 per month on housing without making any changes to his current lifestyle. This is the equivalent of a 30-year mortgage of approximately $200,000 all in.
If you have large student loan balances, you won't be able to afford as much house as someone without student loans. If you are raising children, you probably can't afford as much house as a couple that doesn't plan to have children. If you want to retire at the age of 50, you probably shouldn't buy as much house as someone who is happy working into their 70's. That's reality. We have to make concessions and sacrifice for what we want to accomplish the most important goals.
Another observation in the above example is that person #1 saves a healthy amount for retirement (20% of their gross income). Person #2 is saving less than half of that, which will take twice as long to reach the same retirement goals. If we made all of their expenses equal and Person #2 spent twice as much on the house as Person #1, the savings scenario would be the same. I have found that the amount spent on housing is the number one predictor of wealth accumulation. The less you spend on housing, the more wealth you will likely accumulate.
What Is Important to You?
Do you like to travel? Do you like to dine out at restaurants? Do you like shopping for new clothes? Do you like to upgrade to the latest iPhone every year? Do you want to drive a nice car? Do you want to retire early? Do you want to have children? Do you want to pay for your children to go to college? Do you want to be debt-free by a certain point in life? Do you want to donate a percentage of your income to charity each year?
With limited resources, we can't do everything. We need to prioritize. What is most important to you in life? What are you working for? There is no right or wrong answer, but this will help you determine what deserves the most attention.
If you have a passion for traveling and want to retire early so you can see the world, then keep your housing costs and other expenses as low as possible to afford to travel and invest for early retirement. If you want to live in a big house and pay for your children to go to college, you will potentially have to drive an inexpensive car, minimize shopping and expensive restaurants, and possibly work into your late 60's or even 70's.
Some General Guidelines How Much House You Can Afford
Finance less than two times your income. If you earn $200,000 per year, you probably shouldn't finance much more than $400,000. In the book, The Millionaire Next Door, the authors found that this was a common trait amongst multi-millionaires. They rarely carried a mortgage greater than 2x income.
In the above example, if you want a house that costs $600,000, it would be prudent to have a $200,000 down payment. This should help keep your monthly mortgage payments to a reasonable level, so you can afford to enjoy life, save for retirement, and not feel house poor. If you anticipate a significant increase in income in the coming years, you may be able to bend this rule, but be careful if you're counting your chickens before the eggs hatch. This will also help you comply with guideline number two.
Keep your total housing payments under 20% of your gross income. This includes mortgage payment, interest, property taxes, insurance, and HOA dues. So, if you earn $10,000 per month (before taxes), you will want to keep your monthly costs under $2,000. This should also enable you to have an enjoyable lifestyle, save for retirement, and raise a family without feeling house poor.
Proceed cautiously if considering an adjustable-rate mortgage (ARM). The payments may look attractive initially, with current interest rates as low as they are. Still, if interest rates are higher when the fixed interest period ends, it could result in a significantly higher future housing payment. This caused many people to foreclose on their homes in 2007-2009 and was the premise of the Michael Lewis book, later adapted into a movie, The Big Short. Unless you plan on selling the house before the interest rateadjusts, or have the ability to pay off your mortgage quickly, you are probably better off with a fixed interest rate.
If you plan to move within a few years, it probably isn't smart to purchase a home, unless your goal is to turn it into a rental property. Suppose you sell the house within a few years. In that case, the transaction costs of closing, title transfer, and commission you pay a real estate agent will likely eat up any equity you have accumulated in that short time. The cost of short-term homeownership can be quite significant. You are probably better off renting in that scenario.
General guidelines only get us so far, and the formula banks use to approve you for a mortgage can enable us to purchase homes that we really can't afford. It is crucial to look at your personal financial situation, prioritize your goals in life to find a house that meets your needs and affords you to accomplish your other goals still.
Want to learn more about how much house you can afford? Listen to our recent podcast episode: How Much House Can a Doctor Afford? Watch at theFinityGroup.com/podcast, or subscribe to Financial Clarity for Doctors on your favorite podcast app.
This article is for informational purposes only and should not be construed or acted upon as individualized advice. Any examples are hypothetical and for illustrative purposes only. Consult with a tax professional for tax information pertaining to your specific situation.