What salary do I need to buy a house? I struggled with that question in my 20s and it probably kept me renting a year or so longer than I really needed to be. Then again, considering the housing crisis of 2007-2008, renting a year or so longer was a small price to pay to avoid potentially making the biggest financial mistake of my life.
One of the reasons for that financial crisis was not enough people asking that question. A second reason was banks being dishonest about the answer. For the record, I think buying a house is a good idea and it’s worth it. But you have to be sane about it to keep from getting into trouble.
Working backwards to figure out what salary I need to buy a house
A famous line in the documentary The Big Short asked, “Who the hell doesn’t pay their mortgage?” Collectively, we found out the hard way. People who are in over their heads and can’t afford it, that’s who. The solution is to avoid getting into that situation.
Start out buy finding out what houses cost where you want to live. The answer is very different in Springfield (you pick the state) versus San Francisco. You may want to cast a fairly wide net. For example, when I was in my mid 20s, I knew a lot of people who lived in the St. Louis suburb of Oakville, where the median home price is $212,000. I couldn’t afford a $212,000 house on my $37,500 salary at the time. A friend who had an older sister pointed out that in the suburb of Lemay, it’s easy to find a $60,000 house.
When you’re in your 20s, friends with older siblings can be a great source of ideas. So I asked around about Lemay. I quickly learned I might not fit in the kind of neighborhoods that had $60,000 houses and that I should set my sights a bit higher.
Knowing what houses cost helps you keep things realistic.
The 4x rule
The next step is to do a little back-of-the-envelope math. I like to get more precise than this, but there’s something to be said for quick calculations you can do in your head to keep things realistic. Generally speaking, if a house costs four times your annual salary, you can probably afford it.
I couldn’t afford a $212,000 house on my $37,500 salary. Looking at the other extreme, to live in a $60,000 house, my neighbors might be making $10 an hour. A guy with a college education who published a book at the age of 26 won’t feel too comfortable in those surroundings. I ended up living between a couple who are teachers and whose oldest daughter is a teacher, and a retired couple whose son in law works in the IT department of a hospital chain. That’s about as good of a fit as I could have possibly found. It probably wasn’t an accident.
Now, here’s how to bring that estimate home. What you can actually afford depends on a few things that vary from region to region and I can’t just give you a multiplier.
Fine-tuning the estimate
Once you have some idea what a house costs and what you can afford, I recommend getting a little bit more specific. The IRS says you can afford to spend 30 percent of your income on housing. Regardless of what you think of the government, remember the IRS has a vested interest in you being able to afford to pay your taxes every year.
There’s also more to housing expenses than just principle and interest. 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. For that, set aside about $90 a month in your savings account, no matter what, and use that to pay for maintenance. Not doing routine maintenance decreases your home value, and it’s cheaper to pay it yourself than to get a home warranty.
The answer is to take the IRS guidelines, subtract the expenses from above, and work backwards.
Doing the math
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.
Next, take 30 percent of your income, then subtract the $1,000 for maintenance, the cost of insurance, and the cost of property tax. Using my $37,500 example, that works out like this.
Start with $11,250. Subtract $1,000, to bring it to $10,250. Next, subtract the insurance cost ($1,147) to bring it to $9,103. Subtract the taxes ($2,250) to bring it to $6,853.
Divide that by 12 to get a monthly payment. $6,853 / 12 is $571 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 $571 monthly payment, 30 years, and 5% interest, I get $106,366.80 back out.
That’s less than four times your salary. Remember, you need a down payment. Divide that by .8 because you need a 20% down payment, and you get $132,958.50.
I know that number works because that’s right in line with what I ended up paying. And let me tell you, some months were tight early on. But I never missed a mortgage payment.
Also keep in mind there’s more to buying the house than just the house. You’re going to buy things like furniture and appliances. Buying very basic or even used appliances is a good way to save a lot of money. A good source for nice used furniture is estate sales.
Finding a bargain
There are some easy ways to find a bargain on a house. A bad interior paint job really depresses the value of a house, for example. Most buyers can’t see past that loud bedroom. If you’re willing to slap a few coats of paint on some walls, you can get thousands of dollars more house than you could otherwise afford.
The same goes for a dated kitchen and/or bathrooms. Lack of a dishwasher can cut thousands of dollars off what a house sells for, yet you can put a dishwasher in for less than that. If you find a used dishwasher and can install it yourself, you might even be able to get it done for $100.
As long as the kitchen and bathroom or bathrooms work properly, you can always come back and upgrade them later. I recommend paying your cars off, then renovating the kitchen or a bathroom. Don’t do it too early. Those first few months can be tight.
Worn-out or outdated floors similarly depress the value of the house. If you’re willing to refinish a floor, or lay down some new vinyl, you can save a fortune. Missing closet doors are another easy and cheap thing to fix that drives values down.
What to do if you can’t afford a house
If you can’t afford the house you want, work on getting your finances in order and live beneath your means to the extent that you can. Eat out less, for example. The other thing I recommend you do is talk to the smartest person in the room as much as you can. The smartest guy in the room where I worked from 2005-2009 told me I needed to get into rental property. The smartest guy in the room where I worked from 2009-2012 told me I needed to get into computer security. Find the person in your sphere of influence who will challenge you, and instead of saying you can’t, figure out how to make their impossible-sounding suggestions possible.
Buying a house is worth it, but only once you can actually afford it.
Working in reverse
If you’re curious, here’s a scenario I worked through based on $100,000 of income, if you want to come at the question from the other direction.