How much house can you really afford?

Q: With the drop in housing prices, how do we determine what we can really afford? – T. J., Illinois

A: Buying a new house is an emotional and financial lifestyle decision. In the recent past many homebuyers were encouraged to stretch themselves financially, either to get into a house or to move up. Many of those buyers have run into financial problems, cannot afford their houses or have had them foreclosed upon. This chain of events has created buying opportunities for those who can afford them.

It used to be that most households had one wage earner, so if the wage earner got sick or lost his job, the other spouse could get a job and save the house. Today two wage earners are usually required to be working to buy a home, so what happens if one loses his job or gets sick?

In the past with rapidly increasing housing prices we also had annual increasing wages. Today more companies are using technology to downsize their workforce, while putting lids on how much certain job functions are worth. What’s in your job future?

A good mortgage broker can guide you into almost any priced house you want with the different types of mortgages available. Whether you can afford it later may be another story.

With larger incomes, we have more lifestyle choices readily available to us. We can drive a basic car or a new or used luxury car. We can go out to eat at expensive or inexpensive restaurants, buy prepared foods to eat at home or simply prepare our own meals in professionally outfitted gourmet kitchens. We can have expensive hobbies or inexpensive ones, etc. Yet an important question that few of us ask ourselves is: “When, where and how much do I need to live on for retirement?” The price tag associated with these current and future lifestyle decisions is staggering. Most people cannot have and do it all.

So you probably are going to have to compromise and decide what’s really important to you: a big house in a desirable location with less discretionary spending, a smaller house in a less-desirable location with more discretionary spending, somewhere in the middle or no house at all.

As you look at buying a house, two types of costs are involved, the one-time costs that get you in and the ongoing costs that keep you there. Various lenders have rules of thumb as to how much house you can afford such as:

• Don’t spend more than 28 percent of your before withholdings paycheck on mortgage payments, property taxes and insurance.
• Don’t incur total monthly debt payments greater than 36 percent of your before-withholdings paycheck. 

To decide how much house you really can afford, review the components of these costs, your lifestyle needs, then figure out your own “bottom line.” 

ONE-TIME COSTS

Unless you can pay cash to buy a house, you’re going to make a down payment and take out a loan (or loans) for the balance of the purchase price. Unless it is a private loan, from family and/or friends, the loan will require various fees.

If you are a first-time homebuyer, total your assets that can be turned into cash for your one-time costs. Review bank accounts, stocks, bonds, mutual funds and other sources of cash to determine the total dollars available. Don’t forget to allow for taxes on assets that you liquidate that have built-in gains, such as securities or retirement plan funds.

If you’re a current homeowner and plan to sell your existing home, determine your real equity — the current home value less your debts against the home, estimated selling costs and possible income taxes. 

DOWN PAYMENT

The down payment often is expressed as a percentage of the home’s price. The greater your payment, the lower your mortgage amount and its monthly payments.

Certain mortgage lenders allow you to put as little as 5 percent down if you have good credit, little or no debt, and a solid employment history. Some government-sponsored loan programs allow purchasers to get in with little or no down payment. 

APPLICATION AND CLOSING COSTS

Many mortgage lenders start the loan process by requiring an application fee, an appraisal fee, and a credit-check fee. After your loan is approved, you’ll need to pay closing costs to complete the mortgage. This also may include: points, insurance, escrow fees, attorney fees, title insurance and inspection fees. “Points” refers to prepaid interest fees that lenders often charge to lower their stated rates.

Points represent a percentage, with 1 point meaning 1 percent of the loan amount. (Example: If your loan is for $150,000, and your bank charges you 1.25 points, you will have to pay $150,000 X 1.25 percent, which equals $1,875 in points.) Total closing costs can add up to 1 percent to 4 percent of your mortgage. Take caution here, as points and closing costs can be financed, people may believe they’re not really paying for them. 

OTHER ONE-TIME COSTS

Initial repairs and upgrades to get the house ready for you to move in, moving expenses, furnishings and decorating vary depending on your needs and the situation at hand. You might want to check with some friends, family members or advisers here to determine how much to really budget. 

ONGOING COSTS

Here’s where you need to be honest with yourself, as the ongoing costs of owning a house need to fit within your lifestyle and budget. Start with all your non-housing-related annual expenditures.

Remember to include your income taxes, food, dining out, vacations, hobbies, going to the movies or theater, charitable and family gifts, car payments, insurance policies, retirement savings and college savings. Also include an amount for unexpected expenditures like new tires, appliance replacements, etc.

Total all your expenditures and subtract them from your total income. What’s left is the cash available for your ongoing monthly housing costs plus any expense adjustments or unanticipated emergency expenditures.

Now run the numbers for the annual costs on a house that you’re thinking about buying. Don’t forget the other ongoing costs you’ll have with home ownership: property taxes, homeowner’s insurance, utilities and upkeep. The true costs of running a house in good condition depend on your lifestyle, the age and type of house you buy, and the region of the country where it’s located. 

MORTGAGE

Your largest ongoing housing cost will likely be the monthly mortgage payment. The interest portion should be tax-deductible, which can lower your income taxes and allow you to afford higher mortgage payments. Caution: your interest deduction decreases in later years as more of your monthly payment goes toward repaying principal and less goes toward interest. Also, if you put less than 20 percent down, lenders usually require you to purchase private mortgage insurance (PMI) at an additional cost.

The amount of your monthly mortgage payment will depend on the interest rate, size, length and type of the loan. A small difference in the interest rate can make a big difference in the affordability of a house. An adjustable-rate mortgage (ARM) typically has a much lower initial interest rate than does a fixed-rate mortgage. With an ARM you can initially lower your monthly payments, but as the rate increases you might find it very difficult to make payments and run the risk of losing your home as others experienced.

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This information is brought to you by The NAEPC Foundation and Noverus, your financial and estate planning partners. © Copyright NAEPC, The NAEPC Foundation, Noverus and Valentino Sabuco, CFP^®, AEP®.