Most people never bother to calculate the actual cost of homeownership before they buy, which makes it difficult to know where to set your home buying budget.
The list price of a home doesn’t tell you much about how interest rates will impact your mortgage or how expensive it will be to maintain that house over the time you own it.
And a lender or bank, the place you’d expect to provide guidance given that they’re the ones offering you a mortgage, is not too much help in understanding what you can truly afford before you buy.
While lenders have limits on debt-to-income ratios, all of these calculations fail to factor in a critical cost you will face as a homeowner.
Relying on a lender or traditional advice around home affordability could leave you paying for more house than you can reasonably afford and in a tight spot with your cash flow.
This is what you need to know to make a financially sound decision when buying a home, what you must account for when building your budget, and why at the end of the day, there may be a different path that provides more financial stability than home ownership.
What A Lender Will Say You Can Afford
Most lenders look at two debt-to-income ratios to determine if you can afford to pay the mortgage on a particular house:
- Front-End DTI: This is the amount of your income that you will have to spend on your monthly mortgage payment, the interest on the loan, any payments made toward an escrow account for taxes and insurance, and any association fees.
- Back-End DTI: This is the amount of your income that goes toward all of your debts. A potential mortgage is included here – but so are things like student loan payments, credit card debts, personal loans, and car payments.
There are some major issues with this system.
One is that in following these guidelines, lenders can allow you to take out a mortgage for anywhere between 28% (when looking at front-end DTI) to 45% or even 50% when accounting for your total debt service.
That means a financial institution could allow you to purchase a home that, along with any other debts, could require you to put nearly half your earnings toward it each month.
Given that taxes could take another 20% or so of your income, that leaves you with just 30% of what you earn to use on everything else you need throughout your life, from contributing to retirement accounts to savings goals to any discretionary money you want to do.
This is a good way to become “house poor,” where your house eats up so much of your available cash flow each month that there’s barely anything left over for other needs and wants.
The other major issue here is that these ratios don’t even account for the full expense of homeownership.
Your house could end up costing you more than 28-50% t of your income each month and a lender is not going to account for that reality.
Here’s how you can take matters into your own hands and solve for both these issues, while getting a more reasonable understanding of how much house you can truly, comfortably afford.
Keep Total Housing Costs To 20% (Or Less) Of Household Income
When we run home affordability analyses for our wealth management clients, our standard advice is to (try to) keep housing expenses to 20% of their household gross income.
Here are some examples of how that works out at various income levels. If you earn:
- $125,000 per year as a household, aim to spend $25,000 or less per year on housing costs.
- $250,000 per year as a household, aim to spend $50,000 or less per year on housing costs.
- $400,000 per year as a household, aim to spend $80,000 or less per year on housing costs.
This may seem very limiting, so before you get too upset, know that:
- In practice, trying to follow this guideline means most of the clients we see land somewhere around the 20% to 25% mark once they actually buy their home.
- This guideline can help you determine if buying is even a good decision for you — looking at what your budget affords you if you rent vs. buy can be illuminating.
And, there’s a reason this guideline is arguably, a little low: rare is the person who sticks to any given limit.
If we set our guideline for home affordability at 25% of income going to housing expenses, most people would end up at 30%.
Aiming for 20% in a planning phase creates some margin of safety by pulling you back from spending the absolute most you think you could.
Life is unpredictable and things change. If you constantly try to max out on a suggested limit, you won’t position yourself well to deal with life’s inevitable curveballs because you will have no flexibility with your finances.
Here’s a graph we created to show a slightly wider range of affordability potentials:
The bottom line is this:
Setting the “rule” to limit housing expenses to 20% of your household income is part of how we create wiggle room when providing recommendations.
Remember, this guideline applies whether you rent or buy.
When you rent, the total cost is probably just your monthly rent. (We’ll get into why this can make renting the better financial option than buying in a moment.)
But if you’re going down the buy road, then the next question is:
What costs should you consider when determining the total cost of homeownership, so you can then compare that to your income?
What Counts As Your Housing Costs?
Here is what you should include when calculating your housing expenses:
- Mortgage principal and interest payments
- Property taxes
- Homeowner’s insurance
- Any HOA or condo fees
- An estimate for home maintenance and upkeep
That last point is what most people – even lenders – miss when considering how much house they can truly afford.
You must include some expense to cover the average, general cost of homeownership in your housing budget.
If you want a reasonable margin of safety, we suggest assuming you’ll spend an average of 2% of a home’s value per year on maintaining that home.
If you want to play it a little looser, use 1% instead.
Whichever you use in your calculation, bear in mind that very human tendency to underestimate costs while overestimating income, savings rate, and so on. Also remember that this represents an average.
If, for example, you buy a $1,000,000 home, then your “average home maintenance” cost would be $20,000 per year.
That might sound a little crazy on the surface, but an average does not mean you will pay this set amount annually. It could actually look something like this:
- In year one, you pay $3,000 on landscaping and $1,500 for a new fridge.
- The next year, you need a new $37,000 roof
- In your third year of homeownership, you replace the HVAC system to the tune of $18,500.
That’s an average of $20,000 a year even though you did not write any checks for $20,000 on January 1.
Not to mention, nothing here is crazy or out of the ordinary when you own a house. Ask some homeowners, and they’ll tell you this is actually on the low end of what it costs them for upkeep on their properties over time.
Whether you ultimately want to assume an average of 1% or 2% of a home’s value for annual maintenance costs, make sure to account for it.
You must include this figure when you’re trying to decide how much house you can afford.
How It Looks In Practice: Real-Life Home Affordability Analysis
To help you understand how all the numbers can be pieced together — and perhaps most importantly, why a 20% limit on housing is such a critical benchmark — here are the results of an analysis we ran for a client who wanted to know how much they could spend on a new home.
We accounted for all their income sources and showed how that income could be divided out to their various needs, wants, goals, and liabilities:
By limiting their housing costs to 20% of their gross household income, this client can easily contribute another 25% of their income to long-term investments to grow wealth (another of our signature pieces of advice).
That leaves the remaining 55% of their earnings available to:
- Pay for taxes and benefits (like health insurance through work);
- Put toward short-term goal funding (like buying a new car or taking a big international trip);
- Use on other living expenses (like gas or groceries); and
- Spend on whatever other discretionary spending they wanted to do (like shopping or entertainment)
Allowing their housing expenses to balloon past 20% of their household income would mean either saving less for retirement or financial freedom, or having fewer dollars to go around on other things they want and need in the short term, or both.
After All This, Should You Just Rent Instead?
Calculating how much a house will truly cost you is a great first step in ensuring you make a great financial and lifestyle decision.
Avoiding buying too much house means you create more room in your cash flow for everything else you want to do with your money.
Knowing how much house you can afford also help you decide if you should buy at all.
The rent-versus-buy debate seems endless, but let’s keep in mind that as with all things personal finance, the “right” answer should be personal to your situation.
Someone who disagrees with your take on which is better, to rent or to buy, is likely looking at different variables, has different priorities, or working toward a different outcome than you are.
One thing I do know to be true is that it’s always a nuanced conversation, and a conversation in which home ownership is not the end-all, be-all for everyone.
That’s especially true if buying a house interferes with your ability to otherwise enjoy your life and have available cash flow for other goals and expenses.
Renting can be a great choice, even the financially-optimal way to go, if you:
- Secure a rental you enjoy for the same price as a monthly mortgage payment or less, and
- Take the money you save with lower rent and/or avoiding additional costs of homeownership and invest it in a globally diversified portfolio
Doing so could net you out ahead of homeowners who save and invest less of their income because more of their earnings are eaten up by the (oftentimes higher) cost of ownership.
Again, the”right” answer on whether you should rent or buy (and when, or for how long) is personal to you and your specific:
- Goals
- Core values
- Balance sheet
- Short- and long-term plans
- Location, community, and local market conditions
All of these factors can lead you to a very different answer than the next person.
Yet both you and that next person can have the “correct” answer even when your conclusions are on either side of the endless debate on whether you should rent or buy.
Hopefully, this rundown on housing affordability and how to do a more accurate analysis of how much house you can truly afford helps you find the answer that is best for you.
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