Whether you're a first-time homebuyer or looking to buy your next rental property, you're probably wondering how much you can afford to spend on this property. Where homebuyers often go wrong is in underestimating the effective cost of real estate. There's more involved in a home's cost than the sticker price alone. For instance, closing costs, taxes and administrative fees all affect how much homebuyers can afford when purchasing a new property.
I've worked in the alternative asset investment industry for over a decade. For years, I've worked closely with real estate investors and have seen where some have gone wrong in budgeting for a real estate purchase. In this article, I'll share a basic budgeting guide to help you figure out what percentage of your income you can truly afford to spend on a house.
Associated Costs And Fees
The biggest mistake homebuyers make when purchasing real estate is assuming their down payment and mortgage payment are all that go into a purchase. In fact, there is a range of ancillary fees and hidden costs that increase the effective price of a property, including:
• Real estate lawyer fees.
• Closing costs.
• Interest adjustments.
• Applicable state taxes.
• Home insurance.
• Moving costs.
• Homeowner association, or HOA, fees.
The Conservative Budgeting Approach
If you want to free up as much cash as possible, I suggest spending no more than one-quarter of your income, before taxes, on your mortgage, home insurance and property taxes. If Jane Doe, for example, has a pretax income of $100,000, this would mean she should spend no more than $25,000 on these three expenses in a given year.
This approach is advisable for homebuyers and investors who are averse to risk and want to stay clear of becoming house poor, a condition characterized by homeowners whose discretionary income is low due to disproportionately high housing costs.
The Traditional Budgeting Approach
Those who are slightly more accepting of risk and willing to have a lower discretionary income might be better suited for taking the so-called “traditional approach” to budgeting for a home. This model recommends homebuyers spend no more than 40% of their pretax income on housing expenses.
Therefore, taking the Jane Doe example above, she would spend no more than $40,000 on her mortgage, home insurance and property taxes over a one-year span. The average homebuyer, however, is probably best suited for a middle-ground approach that lands somewhere between the 25% and 40% marks — say, one-third of their pretax income.
Why You Shouldn't Use Affordability Calculators
Beware of online affordability calculators, which often only provide a surface-level overview of basic housing expenses. In most cases, you merely plug your income, house price and mortgage rate into a calculator that spits out your down payment and estimated monthly payment.
Buying a house encompasses much more than just a down payment and monthly mortgage payment. In virtually all cases, these calculators ignore closing costs, the state-by-state variability of property taxes, HOA fees, moving fees, inspection fees and the costs of necessary repairs, renovations or kitchen appliances. Very quickly, what you think costs only $50,000 down ends up costing thousands more in associated costs and fees.
Estimating Closing Costs
Unfortunately, closing costs vary widely by one's location, mortgage broker and lender. As a rule, you should plan for closing costs to reach as high as 5% of a home's selling price. Keep in mind that this is on the high end of the scale, as we've seen many homes close with fees as low as 1.5% or 1.75%.
Can You Afford To Borrow?
Unless you're paying in cash, you shouldn't ask whether you can afford a house but, rather, whether you can afford to borrow for the house. Generally, borrowers should abide by the 28/36 rule, which has served homebuyers well during times of recession and economic market growth.
The 28/36 rule is a simple tool for determining the affordability of a mortgage. This rule holds that your monthly housing costs (e.g., property taxes, condo fees, insurance and mortgage) should not surpass 28% of your monthly gross income, and your monthly debts (e.g., student loans and lines of credit) should not exceed 36% of your gross income. Abiding by this rule generally allows for financial stability for homeowners and prevents buyers from becoming house poor.
Putting It All Together
A recent study found the average American spends 37% of their take-home pay on housing. For many, high spending on housing is unavoidable. After all, there's a shortage of affordable homes in the U.S., where housing prices have outpaced the growth in wages in recent years.
Investors are noticing how well real estate appreciates relative to other assets. However, before investing in homes, they should take a holistic view of real estate costs. Although you may have a $50,000 down payment saved for a $500,000 property, that doesn't mean you can afford the home.
Before finalizing the transaction, investors should ensure they aren't spending more than 40% of their pretax income on a home. For the average American with a litany of extraneous expenses and debts, this figure should be more conservative (e.g., 25-33%). Ultimately, the share you spend on your dream home or rental property depends on your individual risk tolerance and how much money you want leftover to fund your lifestyle.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.