Friday, 3 January 2020

How to Buy A House Without Going Broke | How Much Home Can I Afford

How much house can I afford? This is a question that many people ask every single day and financial experts have come up with a few different rules of thumb to use when answering that question. The 3 rules of thumb that will be going over today are the 28/36 rule, the 30% solution, and the 25% method. 

Let's take a look at each of these individually. 

28/36 Rule

  • 28% Gross Income Goes Towards Your Mortgage Payments

  1. Principal
  2. Interest
  3. Insurance
  4. property taxes
  5. PMI
  6. HOA, Related Fees

The first rule of thumb that people use to figure out how much house they can afford is the 28/36 rule. The 28/36 rule states that you should spend no more than 28% of your gross income on your mortgage payments, this includes principal on the mortgage, interest, insurance, property taxes, PMI if you have it, and HOA and other related house and fees and dues if you have them.

  • 36% Gross income Goes Towards Your Housing Cost And All Other Debt.

The rule also states that no more than 36% of your gross income should be spent on those housing costs and all other debts. Or in other words, 36% of your gross income should go towards your mortgage principal (or rent if you're a renter), mortgage interest, insurance, property taxes, PIM, HOA fees, and other debt payments like a car loan, student loans, or other personal loans.

Advantage/Disadvantages Of Using This 28/36 Rule

The main advantage of using the 28/36 rule as your rule of thumb is that it enables you to purchases the second most expensive house out of these 3 rule that will be talking about today anyway, while taking into account at least some other areas of your financial picture, in this case, your non-housing related debts. And in most situations, so long as nothing horrific happens, people should be able to make these payments without going over budget. The disadvantage or potential disadvantage to using this rule of thumb as opposed to some other rule of thumb when figuring how much house you can afford is that, well, it delegates the largest amount of your income toward liabilities out of any of these 3 rule that we are covering today. In doing so it automatically means that you don't have as much money left at the end of the month to put towards other goals whether that's giving, paying off debts, investing for your future, or just saving for a vacation.

Let's take a look at how this rule of thumb work.

Let's say that John and Jane are looking to buy a new home. Together they earn $72,000 a year or $6,000 a month (roughly the average income in the Us according to the recent data from the Bureau of Labor Statistics) as of this writing. John and Jane's following debts are:

  • $5,000 on a credit card which is costing them $100 a month in minimum payments.
  • $10,000 left of a car loan that has a minimum payment of $185 a month.
  • $30,000 of total student loan debt that has a total minimum payment of $300 a month.

John and Jane's total minimum monthly debt payments add up to $585 a month and account for roughly 9.75% of their gross income. So they are a little bit above the 8% recommendation of this rule of thumb when it comes to the percentage of their income going to non-housing debt, remember, the housing portion was supposed to be 28% of the gross income and the debt was supposed to account for 8% of the gross income to get you up to the 36% limit. but that's okay because that's what gives this rule of thumb an advantage over the other rules of thumb on this list. Because based on these numbers John and Jane would have to either pay off some of their debts before buying a new home or simply adjust how much of their income they are going to put towards their housing costs. In this cases, if they decided to not pay off any of their debts before buying a new home they would need to spend no more than 26.25% of their gross income on their housing costs so that their debts and housing costs together could still be higher than 36% limit on their gross income.

This would mean that the most they could afford to spend on a new home (including the mortgage principal, interest, taxes, insurance, and any related fees) would be $1,575 a month or $18,900 a year.
The amount of home that this would buy John and Jane would vary depending on a number of factors including what the interest rate is that they received, how much property taxes and homeowners insurance is where they live (because this can vary by a surprising amount), how much of a down payment they put on the home and whether or not it was enough to avoid Having to get private mortgage insurance or PMI, and of course, what others fees may have come with the home.

If we assume that property taxes are roughly 1.5% of the home value, homeowners insurance cost John and Jane $100 a month, they have no PMI because they put 20% down on the home, there were no HOA or other fees associated with the home, and they received an interest rate of 4% on the mortgage then John and Jane would be able to buy a home of roughly $270,000 on a 30-year loan and a $190,000 home on a 15-year loan under the 28/36 rule. Like I said, these numbers depend on what the market is like at the time, where you live, what the credit rating is, and a whole of other factors so you really have to do the research with yourself for your own situation because the average can vary so widely for all these things that are almost not even useful. Which why I'm just going over the concept today.

30% Solution

That brings us to the second rule of thumb that people use to figure out how much house they can afford which is the 30% solution. The 30% solution states that no more than 30% of your gross income should be allocated towards housing costs which again, basically includes things listed out before.

  • 30% Gross Income > Mortgage Payments
  1. Principal
  2. Interest
  3. Insurance
  4. property taxes
  5. PMI
  6. HOA, Related Fees

The primary advantage is that, out of the 3 rules we're going over today, it allows you to probably buy the most expensive house. 

Looking back to John and Jane's example from earlier.

They make $6,000 a month, meaning that under the 30% solution they can allocate no more than $1,800 a month to housing costs. Assuming the same scenario we described before this would allow them to purchases a $335,000 on a 30-year mortgage or a $235,000 home on a 15-year mortgage.

Disadvantage Os Using This Method

A potential disadvantage of using this method is that it does not really take into account how the rest of your money is divvied up, or at least it isn't as explicit about it as the 28/36 rule. Technically the 30% solution does advise that you have no more than 20% of your take-home pay going towards non-housing debts, but unlike the 28/36 rule, it doesn't have that second layer for you to adjust your housing costs if you are in a situation where you're up to your eyeballs in debt.  As we just saw using the 28/36 rule in a situation where your debts are higher than recommended it would force you to adjust the percentage of your budget going to housing down so that you could still fit under that 36% ceiling, the 30% solution has no such adjustments. If you followed it to a tee, then you'd basically still be putting 30% of your gross income towards housing and then figuring out your debts another time which could lead to some very tight budgets. That makes a lot of people being house broke.

So if you are up to your eyeballs in debt it may not actually be a smart move to put 30% of your gross income towards housing costs at least if you can avoid it while getting yourself out of debt.

Retiring Early

The same goes who are looking to retire early. Because while having a bought-and-paid-for home is certainly very helpful when going into early retirement, believe me, putting 30% of your budget towards housing, unless you get a really good deal, will probably make it a little bit tougher to achieve your goal of early retirement compared to a more conservative rule of thumb.

25% Method

The 25% method is the one popularized by Dave Ramsy and it states that you should allocate no more than 25% of your take-home pay, towards your housing costs. Know The difference here, the 28/36 rule, and the 30% solution were using your gross income, the 25% method uses your take-home pay. Which undoubtedly make it the most conservative of these 3 rules of thumb and generally works very well especially in situations where you need to allocate a large portion of your income towards other financial goals such as giving, paying off debt, or investing in your future, or saving for your daily expenses. However, the downside is that it can be tough especially in more expensive areas to find a decent house in a decent neighborhood on this little of your income. 

Again let's look back at John and Jane's situation,. they make $72,000 a year which after taxes would look suspiciously like $60,000. Following this rule of thumb that would mean they would need to allocate no more than $15,000 a year or $1,250 a month towards their housing costs. This would enable them to buy a $225,000 home on a 30-year loan and a $160,000 home on a 15-year loan.  Again, that's certainly doable in many areas of the country but it's less easy to find a nice place in a nice neighborhood in more expensive areas of the country for the amount unless of course, you get creative. Because even in those cases that doesn't mean that this rule of thumb, or either of the other ones for that matter, is impossible to follow it just means that we have to look at some of the other options we have available to us.

  • House hacking or rent hacking, whichever is applicable to your situation, are great things to look into in a situation like this. For example, John and Jane can rent out bedrooms or even entire floors (if the house has them) full-time or even just occasionally on a site like Airbnb to others and using that to offset some of their housing costs. So that they can get the net housing costs down below that 25% goal.

Those are the 3 common rules of thumb that are used to help us determine how much we can afford.

  1. 28/36 Rule
  2. 30% Solution
  3. 35% Method


One thing that I do want to add that I'm sure many of you already been asking yourself while reading this, Can we really trust these rules of thumb when everyone's situation is so different? My answer who be it depends. I wouldn't just go with these rule of thumbs blindly, not because they can't work, because they can, but because doing so encourages us from looking deeper into our own situation and trying our best to take into account the rest of our financial picture and our goals, as well as other things that go into buying a new home. Because there are other things to consider beyond these rules of thumb such as how much of a down payment can you afford to make on home, moving expenses, furniture and appliances, how much are they going to costs, do you have to upgrade anything in the home, are there any repair or remodels you may want to do early on, what are the closing costs, and a whole bunch of other things. 

The point is we need to do our research especially with something as big as a house. Definitely, we can use the rule of thumb as a starting point as a way to figure out what some of the cost that goes into housing and what are the ongoing ratio that we want to consider. But we also have to do further research on our own because for many of us a house is going to be one of, if not, the biggest purchases we will ever make so it definitely can't hurt to be a little extra thorough in our investigation.

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