How Much House Can You Afford? Making Smart Decisions When Buying A Home
By Andrea Bereznak
Most of you still recall the aftermath when the housing bubble burst in 2008.
In this hypothetical scenario I'll walk you through many issues we've seen arise. In this story we'll call the main character Tom, shared, crestfallen, that he was declaring bankruptcy. Why? Because he had gotten caught up in the popular idea of the time that real estate prices can “only go up,” and made decisions based on overly optimistic assumptions.
Tom purchased a second home near the end of 2007 with an interest only loan, planning to put in $20,000 of upgrades and then flip it and sell for a $100,000+ profit. Unfortunately, by the time the remodel was complete the bottom of the real estate market had fallen out. Tom could not even sell the home for what he paid, let alone any kind of profit.
Rather than sell, Tom rented the home. Because he hadn’t researched the rental market fully, he found out the hard way that the incoming rent didn’t even cover his mortgage payment. When the tenant lost their job due to the recession, Tom’s house went through a series of unreliable tenants who failed to pay rent, leaving Tom to scramble to cover both his primary home mortgage and the rental home mortgage.
More bad news: Tom’s income was cut when his employer became impacted by the recession as well.
You know how this story ends.
The problem was not Tom’s desire to invest in real estate. The problem was Tom’s decision to purchase more home than he could realistically afford.
Mortgage lending requirements have tightened since 2008, but you still should not rely on your lender’s maximum pre-qualification loan amount as a guide to how much house you can afford. Here are some quick pointers to help you avoid a devastating situation like Tom’s.
General Questions to Consider:
- What will happen if you lose your job? Will you be able to still make the mortgage payment for 6 months if it takes that long to find a new one?
- What if your spouse, your kids, or a family member become ill and need extra financial support from you?
- Do you have the resources to pay for maintenance and repair for a major incident at the home while still meeting your other financial obligations?
Specifically for your primary residence:
- Multiple your monthly take home pay by 0.25.
- This is the maximum amount you should spend on your housing payments.
- This amount includes mortgage principal, interest, taxes, insurance, and HOA, if applicable.
- Calculate your debt to income ratios
- Your mortgage only debt to income ratio should not exceed 28%
- Calculate this by dividing your potential monthly mortgage payment by your monthly income. Multiply by 100 to get a percentage.
- Note: lenders and some financial planners use gross monthly income. If you want to play it safer, use your take-home monthly pay instead.
- If you have other debt, your total debt to income ratio should not exceed 36%
- Calculate this by adding together the minimum payment for all debt and divide that number by your monthly income. Multiply by 100 to get a percentage.
- Same goes here for gross vs. take-home monthly pay.
When considering an investment property:
- Research and firmly understand what you can reasonably expect to receive in monthly rent from the property. Enlist the help of qualified professionals, and consider the property manager’s fees you will pay unless you plan to manage the property yourself
- (trust me, answering the phone at 2am because the toilet is overflowing does not make for a fun Friday night)
- Assume that the property will not always be rented. It can often take multiple months to secure a high-quality renter, and there will generally be a gap in rental income when one tenant leaves before another moves in. Bake in a vacancy ratio to your calculations of annual income from the property.
- Make sure you have 6 months of mortgage reserves in a savings account to cover the mortgage if the property is vacant. Keep this fund full. It will also serve as a maintenance fund for when the A/C unit breaks, the carpet needs replacing, or a pipe springs a leak.
If you need some support determining the amount of house that makes sense for your personal situation, we are here to help. Our office has financial planning experts who have helped many clients make confident decisions in the direction of their dreams. We look forward to doing the same for you.
Call us today for a complimentary consultation at (480) 507-2425
The content in this article was prepared by the article’s author. Voya Financial Advisors, Inc. does not endorse its content, and the views expressed may not necessarily reflect those held by Voya Financial Advisors, Inc.