My wife and I recently moved to another state to be closer to her family. We decided to rent before buying, and we are currently assessing our wants and needs for the next house we buy. We have one child and may have one more, so we will probably be looking for a 3 or 4-bedroom house (the 4th bedroom is optional as long as I have a dedicated office as I run a business from home).
This change will have a large effect on our budget as we are upgrading from a two-bedroom town home to a 4 bedroom home in an area with a higher cost of living. One of the preliminary questions we are considering is how much house we need in terms of size and price – and how much we can afford.
First, Consider How Much You Can Afford in Your Budget
Run the numbers in your budget to determine how much you can afford for your monthly house payment. Be sure to include all associated costs, such as your mortgage payment, home owner’s insurance, property taxes, utilities, etc. More on these costs are below.
What percentage of your income should your mortgage payment be?
There are several rules of thumb regarding the percentage of your total take-home pay your mortgage should consume. Most financial experts recommend your mortgage doesn’t exceed 25-30% of your take-home pay.
You may want to adjust this up or down depending on how much other debt you have or if housing costs are higher in your region. For example, if you have no non-mortgage debt, you may be able to afford more home.
On the flip side, if you have a lot of non-mortgage debt, you shouldn’t get a large mortgage, otherwise, you struggle to make ends meet. (Many lenders use a 36% debt to income ratio as a cutoff point for the lowest mortgage rates).
Second, Consider the Costs of Home Ownership
What kind of mortgage do you qualify for?
Most people can’t afford to pay cash for a house, so you will need to apply for a home mortgage to purchase a house. Mortgage rates are still low, which makes many mortgages relatively affordable. But just because a bank is willing to lend you money doesn’t mean you should get a mortgage for the full amount. You should consider other factors as well.
Consider the length of the mortgage:
The most common mortgage terms are 15 and 30-year mortgages. A 30-year mortgage may allow you to buy more home, but the downside is that it takes longer to repay and you will end up paying hundreds of thousands of dollars more in interest payments. Compare the pros and cons of 15 and 30-year mortgages.
Immediate costs associated with a home purchase
Purchasing a home is expensive. It’s best to make a down payment of 20% or more so you can borrow less money and avoid paying Private Mortgage Insurance (PMI). In many areas of the US, it is currently a buyer’s market, so you may be able to get the seller to pay the closing costs. If not, then don’t forget to factor in potential closing costs in your estimations. Additional costs may include moving your belongings, remodeling, landscaping, new furniture, etc.
Immediate costs to consider: Down payment, closing costs, moving costs, remodeling, landscaping, furniture, and other associated new home costs.
Ongoing costs
Owning a house is expensive. You have to make the monthly mortgage payment (which often includes your homeowner’s insurance and property taxes if you use an escrow account, and PMI if applicable). You may also have to pay Home Owner’s Association fees (HOA) or similar costs, and you should consider ongoing costs such as maintenance and utilities. Many people overlook the cost of utilities when they move to a new location. However, the change can be substantial if you are relocating to an area with extreme temperatures, increasing or decreasing the size of your house, etc.
Ongoing costs to consider: Monthly mortgage payment, home owner’s insurance, PMI (if applicable), taxes, association fees, maintenance, and utilities.
Use a spreadsheet to help analyze your expected costs: We found this spreadsheet more helpful than many web-based calculators because it has more flexibility and can be more easily customized to account for additional payments and other factors.
Third, Consider How Much House You Need
Each family has a unique situation. Some families are expanding, some are set for the next decade or so, and others are contracting.
My parents recently sold the home we grew up in because they no longer have any children living at home. They downsized from a 5 bedroom home with a playroom and open office area to a 4 bedroom home with an office.
They still have guest rooms for us when we visit, but they have less overall square footage and less upkeep, which suits them perfectly.
On the other hand, my wife and I live in a 2 bedroom townhome with our daughter and are planning on increasing the size of our family in the next few years. We need to buy a larger home and relocating is the perfect time to do that.
Here are a few considerations when looking at how much house you need.
How many rooms do you need?
My wife and I have one child and we are considering buying a 4 bedroom home. That sounds large until you know the full situation.
We are planning on at least one addition to the family and I will need a home office for my home-based business. We will also consider a 3 bedroom house with a dedicated den/office, so long as it can be closed off for privacy.
The key to considering the number of rooms is by looking at both immediate and future needs. If you are planning on growing or downsizing your family in the near future, then consider buying a home with an additional room, or one less room.
How much square footage do you need?
Large homes can be nice because they feel more spacious and can give growing children room to spread out. But there are downsides as well.
For example, it costs a lot more to heat and cool a larger home, more square footage and rooms can increase your property taxes, and the tendency for many people is to fill any empty space with clutter – sometimes to the point that people buy a larger house to store their “stuff.”
Storage space is another consideration. Does the house have an attic or basement storage? If so, you may be able to purchase a home with less square footage and utilize those unfinished storage spaces.
How much land do you need?
Each situation is different. If you have children and pets you may want a decent size parcel. If you live in the city you may be comfortable purchasing a townhome with no land.
Be sure to consider how your family situation may change in the next few years before deciding how much land you need.
Start your search on the small side
Start your house search on the small end of the scale and work your way up. Many people buy larger homes than they need and end up spending hundreds of thousands more than they need to over the course of their mortgage and the time they live in the home.
Larger houses usually are associated with larger mortgage payments, higher property taxes, more expensive homeowner’s insurance premiums, larger HOA fees, greater utility costs, and the desire to fill every corner of the house with “stuff.”
Buying a smaller home can save you hundreds of thousands of dollars over the years and requires less upkeep.
Run the Numbers, Then Test Them
A good way to gauge your ability to take on a higher house payment is to work them into your budget before you actually buy a new house. One way you can do this is to change the amount of money in your budget to reflect the expected costs. So if your mortgage payment is expected to jump $500 a month, set that money aside for a few months as part of your normal budgeting. Do this for other spending categories that may increase, such as utilities, home owner’s insurance, taxes, etc. Plugging the numbers into your active budget will help you know if you can truly afford a larger home or not.
What should you do with the extra money you set aside in your budget? I recommend dropping it into a sinking fund which you can use to help cover the cost of the move, new furniture, or other expenses related to moving into your new home.
Do you have any tips for determining how much house you can afford to buy?
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AJC @ 7million7years says
Well, I have $7 Mill. + and my car is $200k …. in Aus that’s what a BMW M3 Convertible costs 🙁
Yes, you can only buy a shoebox (literally) for 20% of most ‘first time entering workforce’ people, so I say that these rules apply AFTER you have bought your first house/car/TV/etc. … they just stop you from buying more too soon AND for over-investing your hard-come-by net worth in ‘stuff’.
AJC @ 7million7years says
I have a couple of rules of thumb, that pretty much answer the question, if you apply them both:
1. never have more than 20% of your Net Worth tied up as equity in your house (i.e. borrow the rest)
2. Don’t let your mortgage payments be more than 25% of your Net Income (i.e. after tax)
Ryan says
AJC,
I like these tips – I think many people ignore #2, especially in areas with a high cost of living.
Regarding the first tip, I”m assuming you are referring to not using more than 20% of your net worth as a down payment, correct? Because as time goes by, your equity should grow, and it wouldn’t make sense for most people to withdraw equity from their home value.
AJC @ 7million7years says
I think it makes great sense for “most people” to withdraw equity from their homes … but, only for the purposes of investing 😉
My overarching rule of thumb is to always have 75% of your net worth in investments.
The remaining 25% can typically be:
20% in your house
2.5% in your car
2.5% in your other possessions
Ryan says
Wow. You’re going to have a nice car when you reach $7M. ($175,000). 😉
The only thing to be careful about when using these types of calculations is for people first starting out, since they won’t have much net worth and it would quickly skew the numbers. I would think there would need to be some minimum new worth to make something like this an effective goal for asset allocation/net worth.
Christine Louw says
Good information and two more things to consider:
1. do not be too conservative when deciding on the price range of your new home. The cost of moving is high; if you can, buy a property that will meet your requirements for a longer time period.
2. make your mortgage payments bi-weekly rather than monthly. This reduces your interest payments and therefor increases the purchase price you are comfortable with.
K.C. says
Good tips, especially the last one. Rosa and I lived on our new mortgage budget for six months before we moved. At the time, we were going from a two-income family to a one-income family and wanted to make sure we could handle the additional expense.
My take on using a percentage of income to determine house payment affordability is that it is a trap that ensnares people into buying too much house. A good way to determine how much house you can afford is to consider how the house payment fits in with your long term goals. For most people, a large mortgage payment and financial independence are not compatible.
Using both incomes of a two-income family to determine how much house to buy is also a trap. You can’t always count on that second income.
Good luck with your house hunting.
Ryan says
Thanks, K.C. My wife and I are excited about buying this house – it should be our home for a long time!
I agree with your statement regarding large mortgage payments and financial independence. My wife and I have a large down payment saved and we plan on getting a 20 year mortgage, with the intent of paying it off early. I”m not a fan of having any debt hanging over my head. 🙂
Great tips, and thanks for sharing!