Answering if can you afford a house and knowing exactly how much when looking for a new house can be difficult, and it should depend on several contributing notions. While “professionals” might tell you that you can spend 3 times your annual income, how true can that really be if they haven’t considered other factors then that? Use the CRISPED System (Credit, Risk, Income, Savings, Plans, Expenses, Debt) to assist you in what to consider before you decide just how much house you can buy.
Your credit score is vital because not only does it determine if you get qualified and approved for the loan at all, but it plays a colossal role in your mortgage interest rate. When looking at the big picture over the life of the loan, a lower interest rate will save you thousands of dollars. In the short run, it will help keep down your monthly payment. A couple hundred dollars on a mortgage payment can be a life saver for some people. If you take the little amount of time to clean up your credit, you can likely afford a more expensive home because of the interest savings. Also, if you have the cash, you can buy mortgage points to help with the interest rate. Your credit score is an integral part of the decision process on what you can afford when looking for a new home.
By risk factor, I’m referring to a number of things that put you’re at risk for defaulting on your mortgage. Let’s discuss job security first. Consider what industry you belong to, where you are in your career, and the probability you will be in either the same situation or a better one in 5. Some industries are at a big risk for layoffs, while others are not. Is your company working with a technology that could easily die off in the next ten years? Do you have a degree and skills that could assist you quickly getting a new job if suddenly fired or laid off?
Another major risk factor to consider is health. While you can’t always know these things a head of time, do you fear you could end up sick with big hospital bills that would put you in a bind? Maybe you’re healthy as can be, but your spouse, parents, or extended family is not. The financial burden could end up falling on you in this situation. You should have a mortgage payment that will allow you flexibility if a medical issue occurs.
Plain and simply stated, the amount of money you take home every month is an integral part of deciding how much you can afford for a house. As I mentioned earlier, a common rule of thumb is that your house loan could be 2.5 to 3 times the amount of your annual income. This is not a bad place to start, but it should be adjusted based on all of the other factors in the CRISPED System.
While your annual income is definitely important, if you don’t consider your expenses and anticipated lifestyle, it can easily be very misleading. We’ll look into that later on.
Savings / Down Payment
The down payment on your new house plays a big role on how much you can afford because it dictates your monthly payment. If you’re able to avoid private mortgage insurance, that could save you around $100 a month. If you to have some extra cash to throw down to keep the down payment at 20%, the total cost of the house you can afford could increase. Once you factor in taxes, every thousand dollar on your loan will end up costing you about an extra $7 a month on your mortgage payment. Saving for a good down payment can be tricky, but it’s well worth it.
After paying for the down payment on the house and closing costs, you should have enough cash left for a six month emergency plan. Depending on your risk factor, it could be more or less, but six months is a solid number to shoot for because frequently that is how long it can take to find a job if you lose yours. For some individuals, putting away at least a thousand a month for savings or vacation funds is vital so consider that if that’s something valuable to you.
Consider your retirement before purchasing a new home. Have you been contributing ten percent of your income to your 401k or IRA? Will a mortgage payment continue to allow you to do this? Worst case scenario you could lose your house, but if you have no IRA (which is protected against creditors) to fall back on, it can be even more financially devastating. You absolutely do not want to find you’re in a situation where you’re 65, unemployed without a retirement income to depend on, and you still have to find a way to pay your monthly mortgage. The bottom line is fund your IRA and do not let your mortgage payment stop you from regularly contributing.
Where do you see yourself in 5, 10, or 20 years from now? The longer you live in your home before you sell it, the more equity you will have in your house. Home values tend to go up over significant periods of time, but if you plan to sell in three years, your home value could be at risk to plummet depending on the market. Consider whether your job might expect you to relocate in a year. If you do not plan to stay in your house too long, common sense says spending a little bit less than you were planning to originally is the prudent decision.
How about going back to school for a masters degree? Do you want to have kids in the near future? Will you be paying for your children to go to college? As you can see, mapping out your future financial plans before you get hooked on an expensive mortgage payment you really can’t afford down the line is a wise idea.
Expenses / Lifestyle
If your expenses are costly and your lifestyle extravagant, it won’t matter if you’re making two hundred grand a year. The real concern is the amount you have left after you account for expenses. Do you always have to have the latest gadgets, designer label clothes, and go on expensive family vacations? If you enjoy this type of lifestyle, ensure that your income is enough above your expenses to account for your new mortgage payment or your decisions could be financially devastating.
Even if you don’t live an extravagant lifestyle, but you have 5 mouths to feed, you are in the same boat here. Do not neglect to weigh your expenses and life style standards when analyzing how much you can spend on a house.
The less debt obligations you have, the more cash you will have free every month to put towards a mortgage payment. I recommend paying off any credit card debt you have before buying a house because with high interest rates, your debt can easily snowball. Anything with an interest rate over 8-9% is potentially trouble.
Ultimately, your monthly debt payments should be manageable. If you have a seemingly reasonable $200 monthly installment in student loans, make sure that payment is not going to jump in the next few years. Often, student loan payment schedules are not fixed. However, they will often work with you if you call and talk to the lender. A small car payment and reasonable student loans are not going to kill you, but consider the total amount of debt you have in mind as well.
So Can You Afford a House?
How much house can I afford calculators on the web are aimed towards how much you can get approved at, but they aren’t normally an indicator of what you can really afford because they just do not know your own unique situation. Keep incentives in mind because the more money a bank can get you to spend, the higher the amount of interest they’ll get through the life of a loan. This is the same principal for Realtors as well. The bigger the price tag of the house a Realtor gets you into, the larger their commission fee. Making a decision solely on what you can get approved for is not a prudent idea. Use the CRISPED System when you start analyzing what you can really afford to spend for a house because ultimately your financial security relies on it.
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The House Mouse housing blog is a resource for new home buyers & owners that answers this question & many more for all things home. We cover everything home related including financial questions, home styles, and even to lighter topics such as turning a house into a home.