The decision to purchase your first home is a big choice that can affect your financial well-being for the next 30 years. If you’ve recently visited a bank or mortgage agency to pre-qualify for a new home, there is a very good chance you were pre-approved for more money than you actually need. Because banks and mortgage companies earn money off the interest you pay on the home, it’s their job to push you into as much house as possible.
But, how much home can you actually afford? As a general rule of thumb, there is a simple equation that can be used to determine what you can afford without breaking the bank. Use these guidelines and always remember to stay within your own comfort zone.
Let’s assume you have a pre-tax income of $50,000 per year, a little bit of credit card debt, and a student loan and car payment.
28% Pre-Tax Threshold
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Experts mostly agree that your mortgage payment, property taxes, and homeowners insurance shouldn’t equal more than 28% of your pre-tax income. If you are earning $50,000 before expenses you shouldn’t extend yourself beyond $14,000 per year in payments or $1166 per month. At this price you can afford a home valued at approximately $140,000 to $150,000.
36% For Debt Payments
With a salary of $50,000 annually, you should set aside $18,000 to pay down debt. This includes credit card debt and other personal loans. Paying down these loans and spending wisely in the future can help cushion your savings account in the event of a job loss or catastrophic event.
8% For Other Established Loan Payments
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Maintain 8% of your pre-tax salary to make other payments including student loans and car loans. With a $50,000 salary, you should save $4000 per year or $333. This might not be enough to pay down your student loans and make a car payment and that’s why managing your other debt more responsibly is important. With less credit card and personal loan debt, you can shift more money into paying down other loans.
Ask Yourself If Homeownership Is Worth The Cost
Based on the generally accepted equation shown above, you would need to earn $36,000 just to cover your mortgage, homeowner expenses, and debt. With approximately $5,000 in annual taxes that leaves about $9,000 per year or $750 per month for utilities, food, gas, entertainment, medical insurance, and other expenses.
Throw in a sudden need to repair a furnace, put a new roof on your home, and other costs, and you might find that 28% reserved for your home expenses is simply not enough.
Homeownership can be a rewarding experience but it’s not for everyone. At the end of the day, you have to determine your own comfort level and ability to pay. Just make sure you don’t overextend yourself.