Being house broke is one of the toughest things to have to deal with when it comes to personal
finance.
And unfortunately, there is a fairly sizable number of us that have experienced being house
broke at one point or another in our lives.
And in the interest of trying to lower the number of home buyers that will end up being
house broke in the future, I thought it would be a good idea to do a quick video on how
much we should be spending on housing.
As is the case with many other big financial decisions there are a few different rules
of thumb that people throw out there when asked the question how much home can I afford
so today we're going to analyze the three major ones, talk about their advantages and
disadvantages, and show some examples of how they work in tandem with the rest of our budget
so that you can decide which rule of thumb would be best for your situation.
Hey everyone Daniel here and welcome to Next Level Life a channel where you can learn about
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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 are the 28/36 rule, the 30% solution, and the 25% method.
Let's take a look at each of these individually.
The first rule of thumb that 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 including the principal, interest, insurance, property taxes, PMI if
you have it, and HOA and other related fees and dues if you have them.
The rule also states that no more than 36% of your gross income should be spent on your
housing and all other debts.
Or in other words, 36% of your gross income should go towards your mortgage principal
(or rent if you're a renter), interest, insurance, property taxes, PMI, HOA fees, and other debt
payments like a car, student loans, or other personal loans.
The main advantage of using the 28/36 rule as your rule of thumb is that it enables you
to purchase the second most expensive house out of these three rules while taking into
account other areas of your financial picture, in this case, your non-housing related debts.
And in most situations, so long as nothing horrific happens, people should be able to
make these payments without going over budget.
The disadvantage or potential disadvantage to using this rule as opposed to some other
rule of thumb when figuring out how much house you can afford is that, well, it delegates
the largest amount of your income toward liabilities out any of these three rules, at least explicitly.
In doing so it automatically means that you don't have 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.
Let’s take a look at how this works.
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
US according to the most recent data from the Bureau of Labor Statistics) and have the
following debts.
$5,000 on a credit card which is costing them $100 a month in minimum payments, $10,000
left on a car loan that has a minimum payment of $185 a month, and $30,000 of total student
loan debt that has a total minimum payment of $300 a month.
John and Jane’s total minimum monthly debt payments add up to $585 a month and account
for roughly 9.75% of their gross income.
So they are a little bit above the 8% recommendation of this rule of thumb when it comes to the
percentage of their income going to non-housing debt, but that’s okay, that’s part of
what gives this rule of thumb an advantage over the other rules of thumb on this list.
Because based on these numbers John and Jane would have to either pay off some of their
debts before buying a 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 new home
they would need to spend no more than 26.25% of their gross income on their housing so
that their debts and housing costs together could still be no higher than 36% of 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 any 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 interest rate they received, how much property taxes and homeowners
insurance are where they want to live (because this can vary by a surprising amount), how
much of a down payment they put on the home and whether or not it was enough to avoid
having to get private mortgage insurance or PMI, and what other fees may have come with
the home.
If we assume that property taxes are roughly 1.5% of the homes value, homeowners insurance
costs John and Jane $100 a month, they have no PMI because they put 20% down on the home,
there were no HOA or other fees associated with the home, and they received an interest
rate of 4% on the mortgage then John and Jane would be able to buy a home of roughly $270,000
on a 30-year loan and a $190,000 home on a 15-year loan under
the 28/36 rule.
The second rule of thumb that people use to figure out how much house they can afford
is the 30% solution.
The 30% solution states that no more than 30% of your gross income should be allocated
towards housing costs which basically includes the same things as before.
Its primary advantage is the fact that, of the three rules we’re going over today,
it allows you to buy the most expensive house.
Looking back to John and Jane’s example from 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.
Assuming the same scenario we described before this would allow them to purchase a $335,000
home on a 30-year loan and a $235,000 home on a 15-year loan.
A potential disadvantage to using this method is that it does not 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.
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 a second layer
for you to adjust your housing costs if you are in a situation where you're 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 going to housing down so that
you could still fit under that 36% ceiling however the 30% solution has no such adjustments.
If you followed it to a tee, then you’d basically still be putting 30% of your gross
income towards housing and then figuring out your debts another time which could lead to
some very tight budgets.
So if you are up to your eyeballs in debt it may not actually be a smart move to put
30% of your gross income towards housing costs if you can avoid it while you get yourself
out of debt.
The same goes for those who are looking to retire early.
While having a bought-and-paid-for home is certainly very helpful when going into early
retirement putting 30% of your budget towards housing, unless you get a really good deal,
will probably make it a little bit tougher to achieve the goal of early retirement compared
to a more conservative rule of thumb.
Which leads us into the third most common rule of thumb when it comes to deciding how
much you can afford to pay for your home.
The third rule of thumb that people use to figure out how much house they can afford
is the 25% method.
The 25% method is the one popularized by Dave Ramsey and it states that you should allocate
no more than 25% of your take-home pay, towards your housing costs.
This is undoubtedly the most conservative of these three rules of thumb and generally
works very well especially in situations where you need to allocate a large portion of your
income towards other financial goals such as giving, paying off debt, or investing in
your future.
However, the downside is it can be tough especially in more expensive areas to find a decent house
in a decent neighborhood on this little of your income.
Again let’s look back at John and Jane’s situation, they make $72,000 a year which
after taxes would look suspiciously like $60,000.
Following this rule of thumb that would mean that we would need to allocate no more than
$15,000 a year or $1,250 a month towards their housing costs.
This would enable them to buy a $225,000 home on a 30-year loan and a $160,000 home on a
15-year loan.
Again, 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 of 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 applicable to your situation, are great things
to look into in a situation like this.
Say John and Jane are living in a higher cost of living area where the studio apartments
in decent and relatively safe neighborhoods go for about $1,500 a month and three bedrooms
are in the neighborhood of $3,600 a month.
John and Jane could take on the studio apartment pay the $1,500 a month plus any utilities
and internet and other things that go into it all on their own or they could move in
with a couple of other people that they trust and split the cost of the $3,600 a month three
bedroom apartment and pay $1,200 each.
Now course we would still have to figure in utilities and stuff but since they're splitting
that as well in the 3-bedroom apartment, I presume, it would still be a more manageable
situation for them then it would be had they gone out on their own.
They could do a similar thing with housing by renting out bedrooms or even entire floors
(if the house has them) full-time or even just occasionally on a site like Airbnb to
others and using that to offset some of their housing costs.
But those are three common rules of thumb that are used to help us determine how much
home we can afford.
And one thing that I do want to add that I’m sure many of you have already been asking
yourself while watching this: Can we really trust these rules of thumb when everyone’s
situation is so different?
My answer would be that these, like many other rules of thumb is it depends.
I wouldn’t just go with any of these rules of thumb blindly, not because they can’t
work, but because doing so discourages us from looking deeper into our own situations
and trying our best to take into account the rest of our financial picture and what else
goes into buying a new home.
Because there are other things to consider beyond these rules of thumb and how much of
a down payment you can afford to make on the home, such as moving expenses, furniture and
appliances that you might need to buy, or at least upgrade, for the home, repairs and
remodels that you may or may not end up needing to do early on with the houses, closing costs,
and a whole bunch of other things.
So I’d recommend using these rules of thumb as a starting point.
Use them as a way to understand what costs go into housing and then do some further research
on your own because for many of us a house is one of the biggest purchases we will ever
make so it definitely can’t hurt to be a little extra thorough in our investigations
to make sure we don’t make any major mistakes.
But that'll do it for me today once again if you enjoyed this video be sure to smash
that like button if you haven’t already, subscribe, and hit that Bell next to my name
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