Buying a new house is an exciting process. It is a major purchase and many of us have dreams about how we want our dream home to look like.
A nice open kitchen with white cabinets and lots of counter space for the instant pot, bread maker and an air fryer? Throwing in a finished basement for the kids to play in would be awesome!
Let’s not forget that beautiful backyard for the kids to run around in.
Beyond the look and style, price and location will probably be major considerations too. If you have school-going kids, the school district might be instrumental on where you decide to buy.
Where the schools are popular, prices are usually competitive too. So how can we ensure that we do not end up house poor after getting our ideal house?
Wants vs Needs
Where large sums of money are concerned, it is often dangerous when the decision involves any emotional aspects. It is easy to be carried away by all the wants that we want in the house and end up buying “too much of a house”.
Buying too much of a house has real financial implications. The house could become a financial burden instead of a place of comfort and peace. This is what is typically known as being ‘house poor’.
Someone is house poor when they spend a large proportion of their income on total home ownership and have trouble affording anything else.
Total home ownership includes mortgage, property taxes, home/mortgage insurance, maintenance and utilities. After paying for these, they have little income left for other financial obligations, discretionary spending and savings.
We have to remember that buying a house is a huge financial commitment. Just going through the house buying process itself can easily cost you $10,000 to $20,000 (typically the costs is about 5% of the house price).
That is just the initial upfront costs. For many of us, we will be further saddled with a six digit debt that runs for 10-30 years.
How to Budget for a House
No two houses are the same and even houses on the same street can be built and priced very differently. Therefore, it is important to have a plan in place in order to not be overwhelmed by the decisions you have to make along the way.
The plans are not set in stone, rather you will refine them along the way as you start viewing more houses and become clearer in your wants and needs vs what is real and available.
Unless you have unlimited funds, it is best to first figure out what is your budget before you start your search for your dream house.
Your budget will include how much downpayment you have and what is the maximum monthly payment you can comfortably afford.
In budgeting for the monthly house payment, please do not make the mistake of just looking at the mortgage Principal and Interests amount. That is only the money that is going to your lender.
You need to factor in your property and city taxes, home insurance, mortgage insurance (if any) as well as regular home maintenance.
Using Income Ratios
There are a few general guidelines and income ratios typically recommended by lenders as an industry standard.
- Buying a house that costs 2 to 2.5 times your gross income. So you if you make $100,000 a year, you can afford a house between $200,000 to $250,000.
- Total cost of home ownership should not exceed 28% of your total gross income.
- Your total debt payment, including credit card debt, car payment, student loans, and child support etc should not exceed 36% of your total gross income.
The Problem with using Income Ratios
The above income ratios are good as general guidelines but is not a one size fit all. The problem with using income ratios is that two families with the exact same level of income are likely to have different goals and obligations.
For example, take two families with the exact same income and number of children. One family chooses for the kids to attend public school while the other prefer a small faith-based private school for their children. In this case, the second family will have less cash available for their housing obligations.
Similarly, if one family enjoy traveling, they might want to set aside a significant chunk of their money income to fulfill this goal rather than have the use the money to buy a bigger house.
Buying a house and taking up a mortgage is a long term commitment, therefore it is important to think a few years ahead and think about what you really want in life before committing to the mortgage.
Even though you can sell your house should your plans changes, just remember buying and selling a house is an expensive process itself. The closing costs for buying and selling often comes up to about 10% of the property price.
So it’s often wise to plan to stay in that house for at least 3-5 years to make buying a house worth it.
Figure out your current and future Cash Flow
I do not recommend just asking your lender for the maximum amount of mortgage that you can afford. Typically, they will give you the largest possible sum because the more they lend to you, they more they can make off the interests of the loan.
It is definitely good to know what is the maximum that you can borrow. But, it is probably not recommended to borrow the maximum amount.
Rather, it would be prudent to take some time to go through your current cash flow and expected future cash flow to come up with a number that you will be comfortable with.
This is similar to setting up a budget for yourself. You sit down and list down all the possible expenses that you might have every month. Assign every dollar of your income to a category. This way you can figure out how much you can comfortably afford as your total cost of home ownership.
So for example, if you current net monthly income after taxes is $5,000. You figured you would spend $2000 on food, childcare, car and other necessary expenses. You would like to set aside $300 for travel and save $700 for retirement.
This will leave you with a maximum of $2000 to spend on your total cost of ownership.
In the event, you choose to spend more on a house, at least you are making an informed decision on what other areas in life to scale down. Maybe you will have to save less for retirement or take less holidays over the years.
In addition, bear in mind that a bigger house typically also means a larger utility bills and depending on where you are, sometimes a larger property tax bills too.
If you are currently renting, I would add an additional 10% of your current rent to the total cost of home ownership for home maintenance expenses
Last but not least, are you planning to buy a fixer-upper? Whether you pan to DIY or hire someone to fix it up, you will need to ensure you have enough cash-flow or savings to cover the costs.
Anything home-related can get expensive pretty fast.
How Much Downpayment Do You Have
The downpayment is essentially a tally of how much liquid assets you have that can be used to pay for the house. Liquid assets include bank deposits and non-retirement account stocks and investment.
You are also allowed to withdraw up to $10,000 from your Traditional IRA for buying your first home without paying the 10% penalty, but you will be required to pay income tax on the withdrawn amount.
The amount of downpayment required will depend on the type of loan that you qualify for and intend to apply to.
|FHA LOAN||CONVENTIONAL LOAN||VA LOAN|
|Minimum Credit Score||500||Typically around 620||Typically around 620|
|Minimum Down Payment||3.5% with credit score > 58010% with credit score of 500 to 579||3% to 20%||0%|
|Loan Terms||15 or 30 years||10, 15, 20 or 30 years||15, 20 or 30 years|
|Mortgage Insurance||Upfront MIP + Annual MIP.|
If downpayment is < 10%, MIP is for life of loan. If downpayment is > 10%, MIP is for 11 years.
|None with down payment of at least 20% or after loan is paid down to 78% LTV||None but you are required to pay a VA Funding Fee.|
|Mortgage Insurance Premiums||Upfront: 1.75% of the loan + Annual: 0.45% to 1.05%||PMI: 0.5% to 1% of the loan amount per year|
|Funding Fee||None||None||2.3% to 3.5% for zero downpayment. 1.65% for 5% – 10% downpayment.1.4% for > 10% downpayment|
If you have 20% downpayment available, it is probably best to go with a conventional loan, so you do not have to pay any extras for mortgage insurance or funding fees.
If you do not have 20% downpayment and do not qualify for VA loans, given the currently low interest rate of ~3.5% for a 30 year mortgage, paying PMI may not be that bad of an idea.
This is especially if you living in an area where property prices are rising rapidly. Prices can easily go up another $10k to $30k in one year in our experience.
However, it is definitely worth it to try to increase your credit score to qualify for conventional loan rather than FHA. This is because for conventional loan, you will stop paying PMI once you have paid off 20% of your loan.
But with the FHA loan, you have to pay mortgage interest for the life of your loan if your downpayment is less than 10%. Although you can refinance it, you never know what the interest rate might be in the future.
Sometimes you have to Compromise
Unfortunately, we live in a real world and not an ideal world. Often, given limited resources and depending on your goals, we would have to make compromises.
In our case, we started our house search in our desired school district. We were renting and the kids were happy in their school. It was considered one of the best school in the entire school district.
Alas, everyone else thought the same. Houses in that area were 30%-40% higher than a similar house in the area for the second best school. We house-searched for two years, but a house of a suitable size for our family was simply beyond what we were prepared to pay for.
Finally, we compromised and found one in the second best schools’ district area. On hindsight, I wish we had started searching in this area earlier. The new school turn out to be great! My kids were happy in school and they had awesome teachers and principals.
Most importantly, we were glad that we had a clear understanding of what we could comfortably afford and stuck by it throughout the house searching process. There were many times we were tempted to just cave in and buy something above our planned budget.
We were desperate enough to even offer bids on a couple of upper fixer. I am so glad we did not end up buying them.
First, neither of us are the handyman sort and second, I learned that home ownership is expensive.
The leak in the garage roof alone cost us 5 grand to get it fixed. It scares me to think how much money we will be hemorrhaging if we had bought an upper fixer instead.
While income ratios are good rules of thumbs guidelines to start with, it’s probably better to sit down, understand your cash flow and expenses and come up with a number that you will be comfortable paying for the next 15 to 30 years.
A house is a house. It’s the people who live in it, together with their lives and their dreams, that make a house a home.
Rather than being house poor, choose to start conservatively. Should your income increase in future, you can always buy a bigger house or start buying investment properties instead.
Everyone has different goals and priorities. Get a clear understanding of what are your money goals and priorities, stick to it and you will find yourself in a better position than trying to over-stretch financially.