Updated: Aug 15, 2020
If you are considering buying a home, one of the most important questions you need to ask is how much house you can afford on your current income.
The most common advice from financial planners is to spend no more than 30% of your gross (pre-tax) income on housing costs. That includes your mortgage, property taxes, utilities, maintenance, and all other costs associated with owning a home.
This article acts as a step by step guide to help you figure out how much you should be spending on your housing costs and avoid becoming house-poor.
What does it mean to be “house-poor?”
If your housing costs are too high, relative to your income, you will struggle to save money or pay for other financial goals. This is what it means to be “house-poor.”
The key point is that you need to measure your housing costs against your income. Many financial experts recommend spending no more than 30% of your pre-tax income on housing costs.
Owning a home is expensive
If you own a home, here are some of the annual costs you will need to budget for as part of your housing costs.
Necessary maintenance (such as reshingling the roof or fixing a broken pipe.)
Renovations and upgrades.
Homeowners Association (HOA) or condo fees
There are three factors that will determine the amount of your monthly mortgage payment.
The total amount of your mortgage.
The interest rate on that mortgage.
The amortization of your mortgage.
If you buy a house, the total amount of your mortgage will be the difference between the cost of the house and your down payment. If you buy a $550,000 house and put down $50,000 as a down payment, you’ll have a $500,000 mortgage.
The interest rate on your mortgage will be largely determined by current interest rates in the economy, your credit history and you're personal financial situation. At the time I write this, it’s not uncommon for new mortgage rates in North America to be 3% or even lower.
The amortization of your mortgage simply refers to how many years it will take for you to pay off your mortgage. In the U.S it’s not uncommon to amortize a mortgage up to 30-years. If you had a $500,000 mortgage with a 3% annual interest rate and a 30-year amortization, your monthly mortgage cost would be $2,103.
If your downpayment on a home is less than 20%, you will need to pay mortgage insurance.
In the U.S, FHA loans require an upfront insurance premium of 1.75% of the value of the mortgage which is paid at closing and an annual premium that ranges from 0.45% to 1.05% of the mortgage.
If you had a $500,000 mortgage, you might expect to pay an $8,750 premium at closing and $2,250-$5,250 each year.
Property taxes and annual maintenance costs
If you’re looking to buy a particular house, you can inquire as to the exact property tax bill you can expect.
As a rule of thumb, you can expect the annual property taxes and annual maintenance costs for owning a home to come in at around 1% of the value of the home.
If you bought a $550,000 house you might budget $5,550 for property taxes and annual maintenance for a total of $11,000.
In North America, we have a cultural obsession with real estate and home renovations.
Home Advisor’s annual true cost report found that the average homeowner in the U.S spent $7,560 on home improvement projects in 2019. That works out to an average of $630 per month.
If you own a home, you better be budgeting for renovations and home improvement projects because they can quickly add up to large amounts of money.
Condo and Homeowner Association Fees
If you own a condo, you will almost certainly be required to pay Homeowner Association (HOA) fees. HOA fees are used to pay for amenities and mutual costs for property owners in the association.
In the case of apartment-style condos, HOA fees pay for common areas, building maintenance and amenities like a gym or pool.
Detached houses in certain neighborhoods also require HOA fees for amenities like neighborhood gardening or luxury services like a tennis court.
The average HOA fees in the U.S range greatly from $218-$571 per month depending on where you live. Of course, these are just averages, it’s not uncommon for HOA fees to greatly exceed $571 per month in some circumstances.
In the U.S, the cost of water, heat, electricity, garbage removal, phone, and the internet is around $2,060 per year.
In the U.S, the average home insurance policy premium is $1,445 according to Value Penguin. Although there is a large variance in cost from state to state.
How much house can you afford?
We have covered in great detail, the costs you might expect to pay to own a home.
Remember that to measure whether you can afford to pay these costs; they need to be compared to your income. Remember that most experts recommend not spending more than 30% of your pre-tax income on all of the housing costs we have discussed.
Here are 5 simple steps to determine if you can afford a particular house
Step 1: Google “mortgage calculator” and find out the estimated monthly mortgage for a house you are looking for. Multiply the monthly mortgage payment by 12.
Step 2: Add 1% of the purchase price for property taxes.
Step 3: Add 1% of the purchase price for maintenance costs.
Step 4: Add an estimate for the annual utility costs.
Step 5: Add the total from steps 1–4 and divide that number by your gross (pre-tax) annual income.
The result will tell you how much of your gross income you can expect to spend on housing costs each year if you buy the property.
For example, Let’s say you make $85,000 per year and were considering buying a $550,000 house.
Step 1: You plan on applying a $50,000 down payment. A $500,000 mortgage with a 3% interest rate and 30-year amortization would work out to $2,103 per month or $25,236 per year.
Step 2: Estimated property taxes= $5,550
Step 3: Estimated maintenance costs= $5,550
Step 4: Estimated annual utility costs=$2,060
Step 5: $38,396 ÷ $85,000= 45%
In this example, someone making $85,000 could probably not afford a $550,000 house (unless they had a significant down payment). If you are spending 45% of your pre-tax income on housing, you are likely to become house-poor.
The consequences of being house poor
You might be thinking, “so what, if I spend most of my money on my house, at least I’ll own my home.”
While owning your home can help you increase your net-worth, you don’t want too much of your net-worth to come from your home. The reason is that accessing the equity in your home can become very difficult, especially if you don’t want to move out of your home.
The more of your income you spend on housing costs, the less you have to save.
If you don’t have money to save, your house will make up a higher proportion of your net-worth.
If you approach retirement age and the bulk of your net worth is tied up in your house, that can present a problem for your financial security in retirement.
In short, buying too much house and becoming house-poor prevents you from building the type of wealth that can provide you true financial security.
Make a strategic decision on housing
Owning a home can be a wonderful experience and can be a good long term financial goal. However, it’s important to remember that there are a lot of hidden costs that homeowners must pay.
Most financial experts recommend not spending more than 30% of your pre-tax income on housing costs. If you want to know if you can afford a house, add up all of the costs associated with owning a home and divide it by your income; if the number is greater than 30% you might need to look at cheaper alternatives or increase your income.
If you overextend yourself on your housing costs, you won’t have much money left over to save. This will result in your house representing an outsized role in your net worth which could prevent you from obtaining financial independence.
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This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.