Written By: Ryan P. Zacharczyk, Certified Financial Planner®, MBA
Buying a home is the biggest purchase most people will make during their lifetime. In addition, taking on a liability (mortgage) payment for as long as 30-years can cause many first-time home buyers sleepless nights. However, purchasing a home not only instills a tremendous sense of accomplishment and pride but is often one of the best financial decisions you will make. Since the financial crisis of 2008 and the accompanying housing collapse, many people have wondered exactly how much is the right amount of home to purchase. Although this answer may be different for everyone, following these guidelines may provide you with the information you need to make the right decision for you:
20% Down Payment – We recommend starting with a 20% down payment for your first house if at all possible. Providing such a substantial lump-sum initially may eat into your savings but it will provide you with enough equity in your home to avoid PMI (Primary Mortgage Insurance) and avoid overleveraging your new home.
PMI is insurance mortgage lenders typically require borrowers with less than 20% equity take on their home to protect the lender from default, but is paid by the borrower. “Wait, what? I pay a monthly premium to an insurance company to protect my lender from my default?”. Correct, that is exactly what PMI is and it is throwing money down the drain if you put less than a 20% down payment on your home. A simple calculation for home affordability is to take your current potential down payment and multiply it by 5. This will get you the home you can afford based on equity. However, what about your monthly mortgage payment?
28/36 ratio – Mortgage companies typically base how much you can afford in a monthly mortgage payment based on the 28/36 ratio. The “28” portion of the ratio is the max they will lend in just your monthly housing expenses, which is comprised of the mortgage, property taxes, and insurance each month. As an example, if your income is $5,000 per month, your mortgage payment, taxes, and insurance should not exceed $1,400/month. In addition, they also look at the “36” in the ratio which says that the total monthly payments of all your debt combined should not exceed 36% of your total income. This means that your car payment, minimum payments on credit cards, student loans, home payments, and all additional debt payments should not be more than 36% of your income. So, in the same situation, most lenders would not want to see monthly payments $1,800 per month. Obviously, this is not a hard and fast rule and there may be some variability in these percentages based on lender and mortgage type, but this should be a good guide for you when calculating your home affordability.
Comfort Level – All of the financial calculations in the world may not help you sleep well at night if you are worried about making ends meet. The last point to consider is what is important to you. If spending a lot of money on other living expenses such as travel, children, education, etc. is a high priority, then you may want to consider a lower monthly payment. If you expect a rapid growth in income, quickly rising property values, or spending most of your family time in your new home, then a larger purchase and monthly payment may be wise. Whichever direction you choose, make sure you can sleep comfortably knowing your home purchase is aligned with your values.
If you would like some additional resources, try these financial calculators:
Purchasing a new house is a big leap, make sure you do the math, think it through, and make the decision that is best for you and your family. If things get too overwhelming, just remember that it’s more than just a large financial transaction, it’s your home!