I frequently get questions like, “How much mortgage can I afford on 100K?” Or any other amount. The amount doesn’t really matter; you can do the math on any annual salary or combination of salaries. The important thing is to do the math yourself. So here’s how to figure out how much mortgage you can afford.
What you can afford isn’t the same as what the bank will lend
Don’t confuse what the bank is willing to lend you with what you can afford. The numbers will be similar but not identical. The bank is looking out for its interests, not yours. There’s a possibility of you failing built in to the equation, and you don’t want that. You want to borrow an amount that maximizes the possibility of you being able to repay it.
There is some regulation on this, but that regulation can vary. The regulation is designed to protect the entire economy more than it’s designed to protect you. So what’s legal may not be in your particular best interests.
When I got my first mortgage, the bank was willing to loan me a ridiculous amount of money. I immediately forgot that amount and went with my monthly budget instead, working backwards from that number. I struggled some months, especially early on. But I never missed a payment. I fared better than many other people who took out mortgages at the time. When the 2007 mortgage crisis hit, my house was still worth more than I owed.
Had I listened to the bank, there’s a good chance I would have been one of those many foreclosures.
What the IRS says you can afford
The IRS says your housing expenses should be 30 percent of your income or less. That number doesn’t change, even though what a bank will lend you is always subject to change. I recommend dropping a few percentage points from that because life happens. Sometimes you’ll have an emergency and it may not be housing related and you may need some financial cushion.
There is a shortcut you can take. You can take your annual income and multiply it by four and come close. The back-of-an-envelope guideline is good enough to use for house hunting purposes. Once you narrow down your search, I like to use a bit more precision.
First, figure non-mortgage expenses
You can’t just spend 30 percent of your income on a mortgage. You have to factor in taxes, insurance, and maintenance. Do a Google search on property tax rate and the ZIP code in question. Then, do a search on average property value and the ZIP code. Multiply the property tax rate by the property value. Finally, do a search on average homeowners insurance rate and the ZIP code.
Maintenance is easier. You can figure about $1,000 a year for that. Some years you may spend zero, but other years, you’ll buy a furnace or a roof. For that, set aside about $90 a month in your savings account, no matter what, and use that to pay for maintenance. When you don’t pay for maintenance, it catches up with you. Also, skip the home warranty. It’s cheaper to pay for the maintenance yourself, and you’ll get better quality work. Having the discipline to change your furnace filter regularly makes your furnace and AC last longer and cuts down your electric bill. But eventually you will have to replace those.
How I figure out how much mortgage I can afford
The answer is to take the IRS guidelines, subtract the expenses from above, and work backwards.
In my case, average insurance rates in my ZIP code are $1,147 a year, and property taxes are 1.5 percent of the value of the property, which works out to $2,400 a year in my ZIP code.
Next, take 30 percent of your income, then subtract the $1,000 for maintenance, the cost of insurance, and the cost of property tax. At $100K, that works out like this. Start with $30,000. Subtract $1,000, to bring it to $29,000. Subtract the insurance cost ($1,147) to bring it to $27,853. Subtract the taxes ($2,400) to bring it to $25,453.
Divide that by 12 to get a monthly payment. $25,453 / 12 is $2,121 after you round down. Always round down.
Now it’s time for some homework. Do a Google search on mortgage interest rates. Get a conventional 15- or 30-year mortgage, not an ARM or interest-only or another gimmick. Find a typical interest rate.
Next, do a Google search on reverse loan calculator. Don’t use a reverse mortgage calculator; that’s different. Plug in your interest rate, your number of years, and your monthly payment. You’ll get a number back out. In this case, with a $2,121 monthly payment, 30 years, and 5% interest, I get $395,103.31 back out.
So that means at $100K, you shouldn’t be buying more than $395K worth of house.
Backing off a bit
I always recommend spending a bit less than that. When you buy a house, you’re probably going to want to do some projects, and that was the piece that seemed to push lot of people over the edge in the 2007-2009 mortgage crisis. They might have been able to afford the initial purchase price, but they couldn’t afford to buy the house and install the kitchen and bathroom of their dreams.
As you look at houses, figure out what you’re going to want and/or need to change after the purchase. You can probably come up with a few hundred dollars to paint some rooms, but major renovations get people into trouble.
For example, if you’re going to spend $20,000 renovating the kitchen, make sure it doesn’t take you over the limit of the 4x-annual-income number. Get an estimate ahead of time, line up financing if you’re going to need it, and figure out what that monthly payment will be. Make sure it doesn’t push you over that 30% income limit. I know that payment won’t last forever, but the first few years of that mortgage tend to be the hardest.
There’s no point in building your dream house only to lose it in foreclosure before you’ve had any time to enjoy it. As hard as it might be, it can help tremendously to wait about five years before you start renovation projects.
Paying off the mortgage early
I recommend paying off the mortgage early. The trick is that once you pay off your other expenses like your car and student loans, you roll those payments into your monthly mortgage payment. By keeping your cars a few years longer and doing this, you can pay your mortgage off in less than 10 years.