A house is probably the biggest purchase of your life that’s why I’ll go over 3 rules of thumb to help you figure out how much house you can afford.
Being house broke is one of the toughest things to have to deal with when it comes to personal finance,
And unfortunately, there’s a fairly sizable number of us that have experienced being house-broke in our lives.
In the interest of trying to lower the number of home buyers that will end up being house-broke
I taught it would be a good idea to write a blog post on How much house you can afford.
As is the case with many other big financial decisions there are a few different rules of thumb that people throw out there when asking the question: How much house can you afford?
So today, we’re going to be analyzing three of the major ones.
We’ll talk about their advantages and disadvantages and show some examples of how they work in tandem with the rest of our budgets so that we can decide, on our own, which rule would be best for our situation.
How much house can I afford?
This is a question that many people ask every single day and financial experts have come up with a few different rules of thumb to use when answering that question.
The three rules of thumb we’re going to be covering today are the 28/36 rule, the 30% solution, and the 25% method.
The 28/36 Rule
The first rule people use to figure out how much house they can afford is the 28/36 rule.
The 28/36 rule states that you should spend no more than 28% of your gross income on your mortgage payments.
This includes the principal on the mortgage, interest, insurance, property taxes, and other related housing fees and dues if you have them.
The rule also states that no more than 36% of your gross income should be spent on those housing costs and all other debts.
In other words 36% of your gross income should go towards your mortgage principal or rent if you’re a renter, mortgage interest, Insurance, property taxes, PMI, HOA fees, and other debt payments like a car loan, student loan, or other personal loans.
The advantage
The main advantage of using the 28/36 rule is that it enables you to purchase the second most expensive house out of the three rules that we’re talking about today while taking into account some other areas of your financial picture (in this case you’re not housing-related deaths).
The disadvantage
In most situations, so long nothing horrific happens, people should be able to make these payments without going over budget.
The disadvantage or potential disadvantage to using this rule of thumb as opposed to some of the other rules when figuring out how much house you can afford is that it explicitly delegates the largest amount of your income towards liabilities out of any of the three rules that we’re covering today and in doing so it automatically means that you don’t have quite as much money left at the end of the month to put towards other goals whether that’s giving, paying off debts, investing for your future, or just saving for a vacation.
Example:
Let’s say that John and Jane are looking to buy a new home.
Together they earn $72,000 a year or $6,000 a month, roughly the average income in the U.S.
John and Jane have the following debts:
- $5.000 on a credit card which costs them $100/MO in minimum payments.
- $10.000 on a car loan that has a minimum payment of $185/MO.
- $30.000 of total student loan debt with a minimum payment of $300/MO.
John and Jane’s minimum monthly debt payments add up to $585/MO and account for roughly 9.75% of their gross income.
So they are a little bit above the 8% recommendation of this rule when it comes of the percentage of their income going to non-housing debts (because the housing portion was supposed to be 28% of their income and the debt was supposed to account for 8% to get them to the 36% limit)
But that’s okay because that’s what gives this rule of thumb an advantage over the other rules.
Because based on these numbers John and Jane will have to either pay off some of their debts before buying the new home
Or simply adjust how much of their income they are going to put towards their housing costs.
In this case if they decided to not pay off any of their debts before buying the home they need to spend no more than 26.25% of their gross income on their housing costs
So that their debts and housing costs could still be no higher than the 36% limit on their gross income.
This would mean that the most they could afford to spend on a new home including the mortgage principal, interest taxes, insurance, and other related fees would be $1,575 a month or $18,900 a year.
The amount of home that this would buy John and Jane would vary depending on a number of factors including:
What the interest rate is?
How much property taxes and homeowners insurance is where they live?
How much of a down payment they put on the home?
And whether or not it was enough to avoid getting a private mortgage, insurance, and of course what other fees.
The 30% solution
The second rule of thumb to figure out how much house you can afford is the 30% solution.
It states that no more than 30% of your gross income should be allocated towards your housing costs
Which basically includes the same things we listed out before.
The advantage
Its primary advantage is the fact that out of the three rules we’re going over in this post it allows you to probably buy the most expensive house.
Looking back to John and Jane’s example earlier:
They make $6,000 a month
Meaning that under the 30% solution they can allocate no more than $1,800 a month to housing costs.
Assuming the same scenario we described previously
This will allow them to purchase a $335,000 home on a 30-year mortgage or a $235,000 on a 15-year mortgage.
The disadvantage
A potential disadvantage to using this method is that it doesn’t really take into account how the rest of your money is divvied up or at least it isn’t as explicit about it as the 28/36 rule was
Because technically the 30% solution does advise that you have no more than 20% of your take-home pay going towards non-housing debts
But unlike the 28/36 rule it doesn’t have that second layer for you to adjust your housing costs if you’re in a situation where you are up to your eyeballs in debt
As we just saw using the 28/36 rule in a situation where your debts are higher than recommended it would force you to adjust the percentage of your budget
By going towards housing down so that you could still fit under that 36%
The 30% solution has no such adjustments
If you followed it completely then you basically still reporting 30% of your gross income towards housing and figuring out your debts
Which could lead to some very tight budgets and a lot of people being house-broke
So if you are up to your eyeballs in debt it may not actually be the smartest move to put 30% of your gross income towards housing costs
At least if you can avoid it while getting yourself out of debt
Same goes for those who are looking to retire early
Because while having a bought and paid for home is very helpful when going into an early retirement
BELIEVE me, putting 30% of your budget towards housing, unless you get a really good deal, will probably make it tougher to achieve your goal of early retirement.
The 25% method
The most common rule when it comes to deciding how much house you can afford is the 25% method.
It was popularized by Dave Ramsey
And it states that you should allocate no more than 25% of your take-home pay towards your housing costs
Now, note the difference here the 28/36 rule and the 30% solution we’re using your gross incom
While the 25% method uses your take-home pay
Which undoubtedly makes it the most conservative of the three rules of thumb and generally works very well
Especially in situations where you need to allocate a larger portion of your income towards other financial goals
Such as giving, paying off debt, investing for your future or saving for some big expense
However, the downside is that it can be tough, especially in more expensive areas, to find a decent house in a decent neighborhood on this little of your income
Let’s look back at John and Jane’s situation:
They make $72,000 a year which after taxes will be approximately $60,000. Following this rule:
It would mean that they would need to allocate no more than $15,000 a year towards their housing costs
This would enable them to buy a $225,000 home on a 30-year or a $160,000 home on a 15-year loan
that’s certainly doable in many areas of the country
But it’s less easy to find a nice place in a nice neighborhood in more expensive areas of the country for that amount
unless you get creative because even in those cases that doesn’t mean that this rule of thumb or either the other ones for that matter is impossible to follow
It just means that we have to look at some of the other options we have available to us
House hacking or rent hacking whichever is more applicable to your situation are great things to look into in a situation like this
Let’s say John and Jane are living in a higher cost of living area
Where the studio apartments in a relatively safe neighborhood go for about $1,500 a month
And a three-bedroom is in the neighborhood of $3,600 a month
They could take on that studio apartment or they could move in with a couple of other people that they trust and split the cost of that $3,600 a month apartment paying $1,200 each
Now, of course, we still have to figure out utilities and stuff
But since they’re splitting that as well I presume it would still be a little bit more manageable than it would be if they went on their own
They can do a similar thing with housing by renting out bedrooms or even entire floors if the house has them.
they can rent them full-time or just occasionally on a site like Airbnb to others
And use that to offset some of their housing costs
By doing that they can get their net housing cost down below that 25% goal
Conclusion to How much house can you afford
Those are the three common rules that are used to help us determine how much house we can afford
Also, I’m sure many of you have already been asking yourself while reading this:
Can you really trust these rules of thumb when everyone’s situation is so different?
My answer would be: It depends
I wouldn’t just go with these rules of thumb blindly, not because they can’t work Because they CAN
But because doing so discourages us from looking deeper into our own situation
And trying our best to take into account the rest of our financial picture and our goals
As well as other things that go into buying a home.
Because there are other things to consider beyond these rules such as:
How much of a down payment can you afford to make on a home?
What are the moving and furniture expenses?
Do you have to upgrade anything in the home?
Are there any repairs or remodels that you may want to do early on?
What are the closing costs going to be?
These can vary so incredibly wildly that it’s really tough to figure a strict average that would be useful information.
So you just have to look into it yourself and it sounds a little overwhelming and that’s a good thing
because then it makes you stop and think about it and probably get a good professional in our corner
But the point is: we need to do our own research especially with something as big as a house.
Definitely we can use the rules of thumb as a starting point
As a way to figure out what are some of the costs that go into housing
and what are the ongoing ratios that we may want to consider
But we also have to do further research on our own
because for many of us a house is going to be one of if not the biggest purchase we will ever make.
So definitely it can’t hurt to be a little extra thorough to make sure you don’t make any major mistakes.
Thanks for your time
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