23 February 2006

Don't bite off too much house

MSN Money has an excellent article on not biting off more house than you can chew. Any first time homebuyer has heard it from older relatives: "buy a little more house than you can afford right now, you'll grow into it". The article lists reasons why that advice worked last generation, but doesn't translate well now.

  • Inflation. Rapidly rising prices in the 1970s and early 1980s meant you could count on hefty annual raises. Today, you can’t rely on double-digit income boosts to make your mortgage payment less of a burden each year.

  • Two-income couples. A generation ago, single-income families were more common. If the breadwinner lost a job, the other spouse could go to work to save the house. With more two-income families needing both paychecks to make the mortgage payment, there’s no one on the sidelines to take up the slack -- unless you put the kids to work.

  • The lending industry. Thirty years ago, it was pretty tough to get a mortgage for more than you could really afford. Today, it’s fairly commonplace. More lenders have loosened their criteria, knowing that the vast majority of their borrowers will do whatever it takes to pay their mortgage -- even if it means trashing the rest of their financial lives.

  • Retirement. A much bigger proportion of the workforce was covered by traditional, defined-benefit pensions 30 years ago -- which means they didn’t have to save massive amounts of money on their own to have a decent retirement. Today, the onus is typically on you to carve enough out of your budget to fund 401(k)s and IRAs.

All of these are great points, but it doesn't help you figure out how much house you can truly afford. There are a few tables to figure out how to calculate how much house you can afford, but I prefer the budgeting method.

Do a budget for six months. That is a long enough time frame to start to figure out necessary monthly expenditures (one year would be better). Using that data, figure out what you can truly afford to spend monthly on a house. Subtract 10% from that amount to give a little monthly wiggle room. Now, subtract $200/month for taxes and insurance (or figure out an approximate amount for houses in your area). Take that remaining amount and plug it into an online calculator to figure out how much house you can afford.

One important last step, though. House repairs generally cost 1-2% of the value of the home each year. So, if you purchase a $200,000 house, expect to sock away at least $2,000 per year for home repairs. Take this amount into account and re-calculate the house you can afford. This will give a little more wiggle room if the house needs major repairs, or if you want to replace carpeting or tile.

We went through a similar calculation when we bought our house. We ended up spending a tad more than we calculated initially, but the house came with a Aon Home Warranty for the first year, which gave us breathing room on repairs. It allowed us to allow our salaries to catch up and gave us a little cushion on repairs.

That's just my suggestion, however. There are tons of resources on the internet on how to determine how much house you can afford. I will suggest one more thing, get a traditional 15 or 30 year mortgage and avoid the interest-only and other bizarre mortgages that have cropped up in the past few years. It will skew your calculations and could lead to a greater chance of default and selling the house for a loss. That's not good.

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