How Much House Can You Afford?

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If you’re thinking now’s the time to pull the trigger on a home purchase, I agree. In fact, I just went in with a friend of mine and bought another house – you’ll be hearing more about that in future posts.

But just because you can buy a house doesn’t mean you should. Consider this recent email…

Dear Stacy,

Like most Americans, my dream was to own a house. My goal was to do it before 30. Well, I turned 30 this January and still have not gotten my first house. After reading your book Life Or Debt 2010, I have slowly climbed out of deep student debt – I had over $15,000 on just one loan.

My question is: Do you think a house that’s $110,000 with yearly taxes in the $4,200 range is to much for a person making $34,000 a year? I currently have $10,000 saved for closing costs and hopefully some down payment. The VA loans don’t require a down payment, but I never want to be in debt again!

My parents told me that’s a normal tax range here in Buffalo, NY. I am going back to school towards a degree in accounting, so I’ll hopefully make more after school is over. (I’m going back to school free on G.I. Bill.)

Also, with the VA loan. there is no PMI. Should I keep saving until I have a more sizable down payment? Or buy the amazingly priced 1,900-square-foot home or one of the others like it in my area?

- Chris

Here’s a video I shot to help answer Chris’ question. Check it out, then meet me on the other side for more…

Now let’s add more detail on Chris’ situation, as well as my advice.

How to figure out how much house you can afford

As I said above, in my opinion, it’s time to buy houses. (Hence my recent story Housing Has Bottomed – Time to Buy.) But no matter how good the deal or strong the desire, buying anything you can’t afford is traveling down the road to ruin.

Let’s start with one of a plethora of online calculators available to answer this question. I used this one from MSN, but there’s a similar one at Yahoo and other sites.

Here are the questions it asked, along with the answers I provided for Chris…

Income and Expenses:
Annual Income: $34,000
Monthly child support: $0
Monthly car loan: $0
Monthly credit card payments: $0
Monthly association fees: $0
Other monthly obligations: $0

Mortgage Assumptions:
Annual interest rate: 4 percent
Mortgage term: 30 years
Down payment: $5,000 (I assumed he’d use half his available savings for the down payment, half for closing costs)
Annual property taxes: $4,200
Annual insurance: $500 (I pulled this number out of the air)

Result:
The max house Chris can afford is $89,134.

As you can see, the $110,000 house Chris has his eye on is a bit out of reach. And that’s in the best-case scenario, since I assumed he has no other debts or monthly obligations.

This occurred because most lenders cap the maximum you spend on a mortgage payment (including taxes and insurance) at 28 percent of your gross monthly income. Chris’ income is about $2,800 monthly – and 28 percent of that is about $790, which would allow Chris to support a mortgage of around $84,000. Add his $5,000 down payment, and you end up with $89,000.

What should Chris do?

Here are several options Chris could consider…

1. Get a partner. I bought my first house in 1978 at the age of 22. It was a four-bedroom, two-bath home with a pool. The cost was $85,500 and my income was – believe it or not – $12,000 a year. How did I do it? I went in on the house with a friend. Together, we were able to come up with the down payment, and because the seller owned it free and clear, they carried back the mortgage so we didn’t have to qualify for a loan. After we moved in, we rented the remaining bedrooms to other friends to make ends meet.

I’m still using a version of that technique today. As I said at the start of this article, I just bought a house with a friend. This one was more expensive, neither of us will live in it, and we paid cash. But the principle is the same: Bringing in a partner requires half the money and results in half the risk.

The potential nightmare of choosing the wrong person for any financial partnership should be obvious and therefore approached with extreme caution. (My rule of thumb: Never partner with anyone with less money than you.) But at least it’s something to consider.

2. Buy a cheaper house. If Chris can buy a 1,900-square-foot house for $110,000, he can surely find something livable for less. He doesn’t say whether he needs that much space – we don’t know if he has a family, for example – but that’s a lot of house for one person.

One of the dumbest things Americans do is buy the biggest, fanciest things they can possibly afford. And nowhere is this mistake more evident than in home shopping. When you work with a real estate agent, the first thing many do is what I did with Chris above: use a formula to determine the most expensive house possible. They then proceed to show you houses at that upper limit, and often above it. Result? You let vanity replace common sense, buy more house than you need, leave no margin for error, and end up furnishing, heating, cooling, maintaining, and paying taxes on rooms you don’t use. Dumb.

Granted, because of the leverage offered by real estate, there’s an argument to be made for buying as much property as you can, especially if your goal is to maximize returns. But if you’re buying simply because you want your piece of the American dream, determine what you need (as opposed to want) and spend as little as possible to get it. There’s no reason to create unnecessary risk by over-leveraging.

3. Wait. Although many experts think the housing market has bottomed, virtually none are expecting an immediate recovery. In other words, there’s no rush. Houses will probably still be affordable next year, or even when Chris graduates with his accounting degree. Something to think about, especially considering houses require time, and he’ll soon be working and going to school.

Bottom line? My advice to Chris is to either somehow share the cost, set his sights a bit lower price-wise, or wait till he has more money and more time.

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