What Can I Really Afford?
In some ways determining the amount that you can afford to pay for a new home may seem like a simple process. You figure out your net income after taxes, then you subtract all of your other payments and expenses other than housing. The answer you get is how much per month you can afford for your new home. You would be right, of course, but it isn’t quite that simple.First of all, banks and other lending institutions have standards that you must meet in order to get a mortgage from them. While these standards vary from company to company, here are some rules of thumb that you can use. First, the total mortgage payment plus property tax plus homeowners insurance AND any association dues, should not exceed 28% of your net income.Second, add all other monthly debt payments for cars, credit cards, student loans, installment loans and the like. Add this total to the total of your cost of home ownership that you calculated previously. The total should not exceed 40% of your net income.
You’ll make adjustments for regional differences. For example, although a home costs more in southern California than in Detroit, because heating and air conditioning is so much less expensive, many lenders will allow slightly higher ratios. Still, the 28% and 40% are excellent standards to use in your planning.
Another way to look at your ability to pay for a new home is to compare all costs of home ownership with the cost of renting. This is too complicated to be determined by a back-of-the-envelope analysis. Some calculators set up for this can be useful*. One key component to consider is that mortgage interest and property taxes are deductible on your Federal taxes. For instance, if you are in a 20% tax bracket, you can assume you will save 20% of your total interest payment and property tax. (i.e. you have net income of $50,000. In a 20% bracket you’ll pay $10,000 in taxes. If you had $8,000 in tax deductions, your taxable income becomes $42,000 and you owe $8,400 – a savings of $1,600 or 20% of the $8,000.) Additionally, some states also allow you to deduct these on your state taxes.
On the expense side, remember a home owner incurs expenses a renter doesn’t, such as utilities, the building’s premises, repairs and upkeep. Apartment dwellers rarely have landscaping expenses, have to replace a roof or pay an exterminator to rid a home of termites, the cost of utilities, new furniture, repairs, and upkeep. Most apartment dwellers do not have high air conditioning bills, landscape expense, or need to replace the roof. Pay special attention to estimated costs of water, trash, electricity, gas, and sewage. Add to your budget a reasonable amount for repairs and improvements.
*A calculator that may be of great help to you in figuring out what you can afford. We also offer a calculator that helps on the decision as to which is economically better, buying or renting.