How Much House Can You Really Afford?
Your budget is the first thing you need to figure out when you decide to buy a house. Almost everyone makes the mistake of not figuring out how much they can afford prior to looking for a house. The first instinct for a lot of people is to ask the realtor on how they could go about figuring out what their budget should be and almost always the realtor would recommend that you go to a bank and get a pre-approval to find how much they would pre-approve you for. The bank typically goes with something called the debt to income ratio. They would typically pre-approve you for approximately 43% debt to income ratio. Also, keep in mind that when they provide pre-approval the banks only consider the principal and interest payments towards the debt to equity ratio. Your monthly payments are more than just the EMI. You will have to factor in taxes, property insurance and HOA if any to calculate you total monthly payments towards your house. People assume that if you are pre-approved, you will surely be able to secure a loan for that amount. I hope it was that simple. Figuring out how much house you can afford is much more complicated than that. You would need to consider several factors prior to deciding you budget for buying a house.
The first thing we did was track our monthly expenses. We kept an excel sheet on our computer where we wrote down all our expenses every day. At the end of every day we wrote down every penny that we spent the entire day. We did this for two months. This helped us give an idea of how much we spend on an average every month. This also helped us decide what spending we needed to cut down on if we needed to in case you need to increase the budget for buying a house. This exercise would give you an idea of how much money you would minimally need to maintain your current lifestyle and how much money you would have left for putting into buying a home.
The next thing we did was identify all the fixed expenses we had every month. What I mean by that is list down all the other loans that we had such as car payments, student loans, credit card payments etc. You might also want to list other fixed expenses, such as college 529 payments that you might be making if you have kids.
Figure out how much money you want to save at the end of each month after all you expenses. It’s always a good practice to keep some money as emergency fund. We have heard experts say that you should typically have anywhere from 6 months to a year worth of liquidity cash as your emergency fund. Another reason to save money is to handle any unexpected expenses such as the furnace and A/c going bad that might come up when you buy a home.
Now you would want to figure out your monthly family income post taxes and all your pre-paids such as medical, 401(k) etc. Now that you have all the elements needed for the calculation, you can figure out how much monthly payments you can afford. In order to calculate the monthly payments you can afford subtract all the expenses listed above from your family income and that should give you the monthly payment you can afford. Keep in mind that this monthly payment that you have calculated includes the EMI, property taxes, insurance and HOA if any.
I know this is a lot of information and to a lot of people this might seems complicated. My friends have used this and it has worked really well for them. This is something that people do not want to spend their time on. But, keep in mind that buying a house is one of the most important decision that you would make as an adult. So, it would be good for you to take the time to figure out what you can afford before jumping into buying a home. I would strongly recommend doing this before you go talk to a bank or a realtor. The reason I say this is because the realtors and bankers always want you to buy an expensive house because the more expensive the house you buy the more money they make. But, at the end of the day you are the one who has to live with your decisions. Also, it’s so much easier to get carried away with buying a house. Almost everyone I know of ended up going over their initial budget. So, it’s highly recommended that you plan appropriately prior to buying the house.
At the end of the day how much you want to spend on the house depends on you. Plan appropriately prior to jumping into buying a house. Nothing beats planning. It’s better to be safe than sorry. House is meant to be a place you create memories to be cherished for a lifetime. You do not want to be enslaved to your house or want it to be a burden.
This is an excel worksheet that I’ve created that would help you calculate the budget for your house.
Please comment with other approaches that have worked for you while deciding the budget for buying a house.