How Much Should I Spend on a Home?
Your guide to determining what is affordable and how much to spend
You have your eye on a home. But, you’re not really sure if it’s in your budget or if the home is priced right. If this sounds like you, then you’re in the right place as both these topics will be discussed in this guide.
If you’re a first-time home buyer, then I’d highly recommend reading this guide fully if you want to be able to answer the question of "how much should I spend on a home?" confidently. Even if you’ve been through the process a time or two before, I’d still recommend doing this. That said, if you’re the type who likes to skip around, then you can do so via the outline below:
- 28/36 Rule?
- What’s Affordable for Me?
- Home Appraisal
- Determining Home Value Yourself
- What’s Next?
The 28/36 rule is a common rule used in the industry by lenders to help them determine how much they'll lend out. This rule says that no more than 28% (also known as the frontend) of your gross monthly income before taxes should be spent on housing expenses and no more than 36% (also known as the backend) on all debts.
Housing expenses includes principal and interest, insurance, taxes, and HOA dues.
Total debt includes housing expenses plus items like credit card payments, student loans, auto loans, medical payments, and so on as long as those payments will be required for the next ten months or more.
As an example, let’s say that your gross monthly income before taxes is $5,610.00. With this monthly income, a lender using the 28/36 rule would cap the monthly housing expenses at $1,570.80 (28% of $5,610). The lender would also take into account all other debts and verify that their total doesn’t exceed $2,019.60 (36% of $5,610.00).
Continuing on, a $1,570.80 monthly payment on a 30-year conventional fixed loan with an interest rate of 4% and a down payment of $60,000 (20%) translates into a home with a purchase price of $300,000.
Now, not all lenders use the 28/36 rule. For some, it’s more of a guideline and for others different methods are used; especially if a non-conventional loan is selected. In any case, it may be a good idea to not exceed the amount allowed by this rule even if a given lender might. Doing otherwise could bring about undue financial stress in the future.
What’s Affordable for Me?
As mentioned, the 28/36 rule is more for the lender to determine how much they’re comfortable with lending out. How much you can actually afford given your other financial goals and obligations is another matter. Ask yourself these questions:
- Am I saving as much as I want to for retirement?
- Am I paying down my other debts as quickly as desired?
- Do I have an emergency fund for things like a sudden car breakdown, a sudden medical issue, surprise taxes at the end of the year, and so on?
- Do I have other goals like setting up a fund to help pay for my child’s college tuition, helping to fund a charity, or even an upcoming dream vacation?
- How much monthly discretionary income do I need to have for things like clothing, movie tickets, restaurants, and so on?
To give more context to this, let’s go over an example scenario for “Jim” using the same monthly income of $5,610.00 as in the previous “28/36 Rule” section. Let’s also say that Jim has a total tax rate of 20%.
As we found out in the "28/36 Rule” section, the max amount allowed for housing payments by the lender under this rule was $1,570.8 and the max on all debts combined was $2,019.60.
Jim’s monthly income after taxes is $4,488. Other monthly expenses for Jim include:
- Family health insurance: $650
- Groceries: $600
- Car costs: $450
- Retirement: $200
- Credit card debt: $200
- Total: $1,900
Jim’s housing expenses for a $300,000 home could look like:
- Principal and interest: $1,145.80
- Property insurance: $125
- Property taxes: $300
- PMI: N/A since Jim is putting 20% down on the loan.
- Maintenance: $250 using the 1% rule.
- Utilities: $300
- Total: $2,120.80
The total for Jim’s current monthly expenses plus the upcoming housing expenses is $4,020.80. A graph of these expenses is as follows:
After paying all the listed expenses for the month, Jim will be left with $467.20. Will this be enough for Jim? That depends. If Jim likes to go on yearly vacations, eat out a few times a week, wants to set up a fund for his kids’ college, likes to set aside money for an emergency (a very good idea), and so on, then it may not be. If not, then Jim will either need to determine which areas of his budget he can reduce or decide to look for a less-expensive home.
If Jim did not perform this analysis beforehand and relied solely on the amount the lender was willing to lend, then he could be left not being able to afford his other financial goals.
This all boils down to the following. If your monthly income after all housing expenses and other debts and expenses is sufficient to meet all of your financial goals and obligations, then home ownership will be far more enjoyable in the long run. A bigger home can seem exciting at first. But, that excitement will soon fade away once you realize that you’re being forced to give up other things that are important to you in order to afford that bigger home.
If you have any doubts about your financial future, then it may be wise to discuss your long-term goals and other financial concerns with a financial adviser before deciding how much you can really afford for a home.
In the end, how much you can afford is a partially subjective question and one that only you can truly know. Just be wary of the number lenders provide as that number doesn’t always take into account your full financial situation and future goals.
There are many costs associated with a home purchase with a number of those being one-time closing fees: appraisal, origination, title search, attorney, and so on. These fees can cost several thousand dollars.
If you stay in your home for the long run, then these fees will likely be made up over time as the value of your home grows. But, if you need to move soon after buying your home, then it’s essentially lost money.
This is where underbuying comes in. You may be a financially conscious person – there’s a good chance that you are if you’re reading this guide. And being a financially conscious person, you have decided that you don’t want to buy more of a home than you need.
For example, let’s say that you move into a home with two bedrooms. This works just fine for you and you’re not spending any more on housing than you need. That’s the smart choice right?
Well, within the year you get married and your spouse and you decide that you want to start a family. Soon, you realize that there really isn’t enough room and are forced to buy a bigger home – again paying for another round of closing costs.
Now, many buy a “starter home” initially and move up latter. It’s important to note that there’s nothing wrong with this if a smaller home is what’s in your budget. If you can afford a larger home initially though, then it’s in many cases in your best financial interest to do so if you know that you’ll need a larger home within the next few years.
We’ve already gone over the affordability question in the “What’s Affordable for Me?” section so we won’t repeat that information here. This section will instead focus on the following question, is there anything wrong with buying a larger home than I need if I can comfortably afford it?
The short answer to this question is no. To some, having a lot of space, even space they don’t really “need”, is important and that’s just fine if that’s a priority for you. That said, if finances are your top priority and you do overbuy, then you could be wasting money outside of the more obvious higher initial purchase price.
For example, if 1,500 square feet will cover what you need now and in the future, then buying a 3,000 square foot home would mean that you’re paying for heating, cooling, insurance, property taxes, and maintenance on an additional 1,500 square feet that you don’t really need and these are costs that will never go away as long as you own the home.
The important point here is that home affordability does not necessarily equate into what’s best for you long term. Consider what you really need vs what you want and contrast that to other things that are important to you (e.g., clothes, restaurants, vacations, movies, etc.). If a bigger home tops that list and it’s affordable, go for it. If not, then you may be happier with a smaller home.
An appraisal’s purpose is to determine the value of a home. Virtually all lenders will an appraisal before lending money to you. Why?
A lender requires an appraisal because a lender doesn’t want to lend out more than the home is worth. If a lender were to do so and the borrower on the loan defaulted, then the lender could be left with a property that will cost them money and lenders that lose money don’t tend to stay in business very long.
To perform an appraisal, the appraiser (individual performing the appraisal) will look at a number of things like:
- Home upgrades
- Home condition
- Age of home
- Home’s square footage
- Lot size
- Recent sale of similar properties in the area
Considering all this information, the appraiser will generate a report with the home’s appraised value along with the details around how the appraiser reached that conclusion.
A home appraisal's cost will vary depending on the property’s characteristics and location. For example, if a property is one of a kind, then it could take the appraiser more time to determine its worth. Or, if the property is very large, then the appraiser will have more to cover in the process of generating the appraisal. That said, an appraisal tends to be in the range of $300-$400.
If the appraisal comes out at or above what you’ve agreed to pay for the home, then you’re in the clear to proceed. If it comes out less though, then it can derail the loan as the lender won’t lend more money than the home is worth as previously mentioned.
When it comes out less, you have some options. The first is to negotiate with the seller to lower the price. In many cases, the seller will be reasonable, the price will be lowered, and the loan process can proceed.
In other scenarios though, the seller may disagree with the appraiser’s assessment and may not be willing to negotiate on the home price. When this happens, you can choose to get a second appraiser’s opinion, decide to pay out of your own pocket up front (not with the loan) to cover the difference, or decide to move on to other home opportunities.
Also, be careful not to confuse a home inspection with an appraisal. An appraiser’s job is to consider the value of a home. A home inspector’s job is to consider the condition of a home. A home inspector will not tell you how much a home is worth and an appraiser will not tell you in any real detail the condition of the home.
Determining Home Value Yourself
Appraisals aren’t cheap and you likely won’t be ordering one for every house that you’re interested in. By the same token, you don’t want to get into a situation where your loan is derailed because the purchase price is over the appraised value. What do you do?
A good approach is to determine a home’s value to a reasonable degree up front. No, this won’t be as accurate as an appraisal. But, it can still be incredibly useful.
There are different methods to do this but the best in my experience is to compile a list of comparable homes (similar size, condition, features, etc.) in the same area that have recently sold, similar to what an appraiser would do. There are some resources out there that you can use to do this like:
- Zillow®: Zillow has a slick set of tools that you can use to search in a given area and see the price of homes that have recently sold.
- Trulia®: Trulia also offers some excellent tools to retrieve the sale price of recently sold homes.
- Real estate agent: A good real estate agent will be able to pull comparable homes in your area and generally have tools available to them that can generate an estimated value. The number a real estate agent comes up with will in many cases be very close to that of the appraiser. If you don’t feel comfortable coming up with the value on your own, then a real estate agent is your best bet.
By recently sold homes, this is referring to homes that have sold in the last six months at most and more ideally three months or less. Home values can fluctuate a great deal over time. Last year's home values will not be all that useful in determining today’s worth.
Using this information, you should be able to determine if the home’s asking price is at least close to comparable homes. If too far off, then you may decide to just move on. If in the ballpark, then there’s a better chance for you and the seller to come to an agreement and for the seller to be more receptive to negotiations if the appraisal price does end up coming in a little lower than the current offer amount.
What Have We Learned?
To recap, we’ve learned:
- How the amount a lender will lend and what’s affordable for you are two different things.
- The consequences of underbuying and overbuying.
- What a home appraisal is.
- Some methods you can use to determine home value.
Using this information, you should be able to more confidently answer the question "how much should I spend on a home?".
Click the following to take a quick quiz on what you've learned here:
How Much Should I Spend on a Home - Quiz
You have a good idea of how much you can afford and how much you’d be willing to spend on a home. You’ve also started to look at some homes that fall within your price range.
A good next step can be to find a real estate agent. What is exactly is a real estate agent though?
What Is a Real Estate Agent?