One of the very first things you should ask yourself as you begin your journey of purchasing a home is this age-old question:
How much should I spend on a home?
Every potential home buyer enters this process with a unique situation and set of circumstances. Therefore, it is important to consider the fundamentals of creating a budget and to seek out guidance to help you along the way.
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Starting with the two things that you need to concern yourself with – what price home will your budget allow for, and what price home should your budget allow for? The main difference is what will a lender approve you for and what you’re comfortable with spending. We’ll dive into how lenders calculate your debt-to-income ratio (DTI) to know the maximum you can be approved for.
However, is that maximum amount realistic? We’ll walk you through the general rule of spending not more than 25% of your pre-tax income on a mortgage payment.
We’ll also be covering the three main sections that will help you understand what you should spend on a home:
- Creating a budget and understanding how much you actually spend monthly
- Looking at both your budget and the amount a lender will approve you for
- Short-term and long-term planning, considering your career, living expenses, rent increases, and housing expenses.
When embarking on the exciting journey of purchasing a new home, it’s essential to be aware of your financial limits and to plan responsibly. Keep in mind that the amount you can afford isn’t always the same as what you should spend on a home. It’s crucial to remember that the amount a lender is willing to approve you for is not necessarily the same as your ideal budget.
We’ll start with the two things you need to keep at the forefront of your budgeting mind:
- What price home will your budget allow for?
- What price home should your budget allow for?
The main difference between the answers to these two questions concerns the amount a lender will approved you for versus the amount you’re comfortable spending. Now, let’s start with what a lender will approve you for (which is actually the easier number to get ahold of). This part can be a bit confusing, so we’ll break it down for you. Lenders consider a number of factors when considering you for a loan, one of which is a metric commonly known as debt-to-income ratio, or DTI. There are two kinds of DTI: front-end and back-end.
Front-end DTI consists of housing expenses－this will be your mortgage interest rate, taxes, insurance, and any applicable HOA fees－divided by your pre-tax income. In simpler terms, it’s your mortgage divided by how much you make before taxes. This number ranges from 31% to 40%, but we’ll use 31% for example: if you make $10,000 a month, your total mortgage payment cannot exceed $3,100 (up to $4,000, depending on your credit and which program you’re looking at). That’s the maximum you can go. With that calculation, a lender is not going to approve you for more. So, you’d be looking at a payment between $3,100 and $4,000.
Back-end DTI starts off the same as front-end in that it considers the total sum of your housing expenses (principle, interest, taxes, insurance, and HOA if applicable). Where it differs from front-end is that back-end DTI also takes into account all of your other debts, such as auto loans and credit card payments. The entire sum of these expenses is then divided by your pre-tax income. Since the amount of debt is higher in a back-end DTI calculation, the resulting percentage will be higher. In the case of FHA, the standard is 43%, though higher credit can get you upwards of 50% (and sometimes even higher than that).
Let’s assume that you have car payments, credit cards, and other miscellaneous debt that adds up to about $1000. With a yearly salary of $120,000 and $1000 in debts, we’ll add a DTI of 43%. In this example, your mortgage payment plus all your other debts cannot exceed $4,3000, which is 43% of $10,000 a month. This would mean that you could go up to $3,300 a month in your mortgage payment with a thousand dollars a month in debts. At the high end, you would be able to go up to a mortgage payment of $4,000, plus that $1000 a month in debts. Whichever is most restrictive will be the limiting factor for your lender.
That’s your budget right there! The maximum amount you would be able to go in this example is $4,000. However, is that maximum amount realistic? More specifically, is that an amount you’d actually be comfortable with?
There are several different budgeting philosophies one could consider here. One general rule suggests that you don’t spend more than 25% of your pre-tax income, while another says no more than 25% of your take-home income. Let’s use our example salary of $10,000 a month: to keep within that 25% margin, your monthly mortgage payment would have to be no more than $2,500, which is significantly less than what a lender would approve you for. So, what should you do?
Remember that every home buyer is different; your lifestyle expenses, cost of living, etc. will always vary person to person. For this reason, we suggest using two numbers as a starting point to gauge your target monthly payment:
The lender approval amount should be your maximum limit, while the 25% rule amount should be your minimum limit.
Keeping this in mind, let’s move on to the actual mechanics of formulating your budget.
This section will cover three main areas to help you craft your budget:
- Creating a budget to understand your actual monthly expenses and spending
- Considering your budget in relation to the amount a lender will approve you for
- Considering the short-term and long-term planning factors of your financial life (such as career, living expense, rent increases, and housing expenses)
CREATING YOUR BUDGET
As an added resource, we have also shared an actual budget Google sheet so that as we walk through the different line items, you can see and understand where your money is going. For the most consistent organization, you should be updating this sheet every month.
This budget sheet has two main areas: projected and actual. ‘Projected’ will be your estimated/target budget, whereas ‘actual’ will be what you actually spent in each category (the purpose of which is to see how close you were to what you had budgeted for that month).
Time for a budget exercise! Using your own information (i.e. bank statements, credit card statements, etc.) and memory of what you spent money on last month, fill out our Google budget sheet to the best of your ability. If you don’t have the info in hand right now, you can always try saving your receipts for a month and then running through the exercise again. Now, you can see that each section has a ‘projected’ column and an ‘actual’ column. Again, ‘projected’ is your budget, ‘actual’ is what you really spent. Get ready for an eye-opening experience here, because you’re about to see where your money has actually been going.
Let’s talk about each of the different sections and how they play into your budget.
- INCOME: This is any money that regularly comes into your household. It’s best to be conservative here. If you regularly get commissions or bonuses, but they may vary month to month, try to use what you would average throughout the year. If you do any side work or get any regular extra income, this is also where you would put it. Keep in mind, it’s okay to not put an amount in ‘projected’ if it’s not a regular source of income; you’ll add it to the ‘actual’ at the end of the month and you can see how much more money you’re making on these extra side projects throughout the year.
- EXPENSES: Generally, these are your must-have expenses, such as rent, utilities, phone bill, etc. Since this budget works well with homeowners as well as renters, depending on your situation you may leave some line items blank, like home improvements or maintenance, which may already be covered by your rent.
- DAILY LIVING: This is also a section for must-haves, but it’s more discretionary. Included are things like groceries and clothing, as well as less essential things like dry cleaning and eating out. This is where you can really start considering areas in which to cut back some costs, but money will still regularly be spent.
- CHILDREN/FAMILY: Obviously, they’re not free! Everything from medical expenses to school, lunches, daycare, etc. These expenses tend to be rather fixed, but it’s still important to see just how much of your money is being spent here month to month.
- TRANSPORTATION: This will be things like car payments, maintenance, and registration; if you regularly take public transportation, put that cost here.
- HEALTH: Gym memberships, doctor/dental visits, payment plans for dental/orthodontic work, etc. is what you’ll put here. Health is, as we all know, a crucial area of your life, so you want to make sure that you have enough money to properly take care of it all.
- INSURANCE: Some types of insurance will naturally fall into other areas of your budget; even so, you might have something like extra life insurance or rental insurance, the cost of which isn’t already allocated elsewhere in your budget. This is also a helpful section to track those small extra insurance costs that you don’t really notice coming out of your account. Every dollar will count when you’re looking at your budget.
- CHARITY/GIFTS: Do you give a donation at church every Sunday? Do you spend money on every holiday, birthday, or anniversary for gifts for your loved ones? Track that, because if you’ve got a big family for whom you’re constantly buying gifts, it’ll add up…fast. This is a great way to keep track and see just how much that cost is actually impacting your budget.
- SAVINGS: You should have an emergency fund that has at least $1,000 in it at any given time. Try to put money away on a regular basis, the more the better. We a
Always suggest having some kind of small auto transfer to your savings account on payday, just to make sure that you always have some emergency cash available. Any other investments (that aren’t automatically deducted from your paycheck) could also go here.
OBLIGATIONS: These are things like student loans, credit card payments, personal loans, and any other monthly credit obligations that you have. If you’re not sure what else would go in this category, think of the things on your credit report that you aren’t able to change. Oftentimes, things like student loans or credit cards will be long-term costs that you’ll always be paying. This can all add up quickly, especially if you use any buy-now-pay-later programs. Put that monthly mountain here for all your purchases as well really track to see how much that’s costing you and affecting your budget business expense. Additionally, if you have extra expenses associated with a source of side income, such as spending money on gas as an Uber or Instacart driver, this is also a great place to note those costs as well so that you can compare the costs versus income of those side hustles.
ENTERTAINMENT: We all need balance in our lives, and so this one will get filled up. Maybe this gets heavier during summer. Maybe you like staying home and your books are the most expensive thing on here. Either way, make sure to put a dollar amount to everything you spend for entertainment. If you go to a carnival or a theme park, the cost of park food tickets and anything else would go here.
MISCELLANEOUS LOANS: If you’ve got payday loans or something that doesn’t fall under the obligations section, put it here. If you have a lot of buy now, pay later, this could be a good section for that. This is also a good section if you’re paying back a friend or family member, and it’s not something easy to track.
SUBSCRIPTIONS: Not for entertainment or business purposes, but maybe you have to pay for parking or dues for a membership or a club you’re part of. This is where you would want to put that.
VACATION: If you’re spending any money on vacations or if you often go on weekend trips, this is a good place to put that. It’s also really eye-opening to track exactly what you spend on a vacation to see how much that really impacts your budget.
MISCELLAENOUS: This last area is for anything that isn’t already categorized, such as bank fees, or postage if you mail things often. This area is good to see what you might be spending money on that doesn’t fit into the other categories.
Now that you’ve documented your budget, the top of the document will automatically add everything up and tell you how much of a surplus or loss you’ve made at the end of each month. Once you fill this out for a month, you can also see how much variance there is from your projected and your actual budget. We suggest making a new tab for each month and use this to gauge how much you are really spending.
You can start moving around different numbers and see how much increasing your housing expense, daily living, or even how much you’re putting away for savings, will affect your overall budget. As we mentioned above, 25% of your take home pay is a great gauge to what you should aim for when purchasing a home. Try putting that amount in your housing payment field and see how that affects your budget. Does it keep you with enough money that you aren’t house poor and struggling to make payments? You can try increasing your number and just see how it affects your savings and lifestyle.
YOUR BUDGET VS YOUR LENDER
Now that you’ve got the tools to better understand what kind of home you can afford based on what you’re currently spending, as well as what a lender would approve you for, now is the time to take both those numbers and start considering what you can afford for a mortgage payment. Using the amounts that your budget can afford and that your lender will approve your for as the maximum range, think about what payment will work best for you.
You absolutely can’t go over what a lender will approve you for, and you can’t go over what your budget says you can afford. If you have more expenses than others, especially expenses that don’t show up on credit reports－club memberships, a lot of dining out, or maybe you like taking a lot of vacations－your budget will likely be your limiting factor. Use these to decide where you would be most comfortable.
Another technique to try is starting with the max lender payment, plugging that into your current budget in this Google sheet, and seeing where that puts you slowly back that down and see where you’re most comfortable and run that through a payment calculator to see what that home amount is that will give you your budget.
Keep in mind, though, this all assumes your overall payment, income, and lifestyle don’t change over time. So, now let’s talk about that third area to consider.
SHORT-TERM AND LONG-TERM PLANNING
This section covers how your career, living expenses, rent increases, and housing expenses should all factor into your plan. Buying a home is an investment in your future, and it’s important to have a plan for both short term and long term. You need to consider things like job stability, potential rent increases in the area, housing expenses, including the cost of upkeeping, repairs, insurance, etc. All of these should be factored into your overall budget when you’re looking at purchasing a home. So, let’s break down the short term costs versus long term when moving from an apartment or small home to purchasing a single family home.
Rates
The Department of Housing and Urban Development has a fair market rental rate, the data for which goes back to 2000. For this example, we’ll look at the data from the last 10 years for Riverside County (which is right next to San Diego, Orange County, and LA County). It’s a relatively affordable area for Southern California, which makes it a helpful benchmark in terms of cost. In 2013 in Riverside County, a three-bedroom rental averaged $1,577 a month. In 2023, 10 years later, a three-bedroom rental averaged $2,376 a month. That’s a 50% increase in just 10 years.
Now let’s look at purchasing a three bedroom home using those same dates. In April, 2013, the average purchase price for a single bedroom single family detached home in Riverside County was $240,000. Interest rates were at about 4%; if you put just 3.5% percent down, your monthly payment would be about $1,585. In this scenario, you would have been breaking even right away, and in less than a year, it would’ve cost less to purchase than to rent.
However, nowadays (April of 2023), the average purchase price for a three bedroom home is $565,000, and with interest rates in the low 6%’s, your monthly payment would run you about $4,250. Using the same numbers and interest rate (about 4%) as 2013, your payment would have been $3,552.
Now, looking at that three-bedroom rental at about $2,376 a month, if we expect that to go up at the same rate as it did over the 10 years, we could expect that number to increase to $3,564. That’s within $10 of what that mortgage payment would be at that 4% rate.
What this demonstrates is that that 10-year mark is when it really becomes apparent that that rental is actually starting to cost you a lot more than if you had purchased a house and were paying a monthly mortgage. And again, that rental cost might go up even more if there’s higher demand for rentals.
Another important detail to consider is that every single month, a portion of what you’re paying in your mortgage, the principle amount, contributes to building the equity in your home. Year after year, that money continues to build, and that value is yours. When you sell the home, that value comes back to you. When you rent, every single payment is going towards someone else’s mortgage, someone else’s equity, and someone else’s principle coming back to them. So in the long-term, where is your money really going? If you’ll end up paying about the same in rent as you would in a mortgage, why not instead work on building equity and generational wealth?
Home prices have outpaced wage increases, and with inflation, it’s not quite the same as it was 10 years ago. These are the types of things to think about. Nobody wants to overpay for a home, but real estate is one of the few assets that consistently appreciates over time. An average home appreciates between three to 6% annually. And when we look at average home price index appreciation from 1975 to 2014, California homes appreciated 6.77% annually, Colorado at 5.25%. Florida 4.09, Georgia at 3.49 North Carolina at 4.06% New York at 5.57%, and Virginia at 4.92%, to give some general examples across the country.
If you’re currently renting, you can expect your rent to increase anywhere from one to 5% each year. So far in the last 20 years, the national median rent has increased at an annual rate of 4.17% year over year. Rent changes have not fallen to a negative rate, meaning year over year. They didn’t go down since 1934, so you shouldn’t expect your rent to ever drop or even stay the same from lease to lease.
Essentially, what we’re getting at here is that you can expect the value of your home to increase while your payments stay the same, but you can count on your rent to increase each year without adding value to an asset that you own. Consider that into your affordability calculations; is there a high demand for rentals in your area? Will that drive up the cost of what you’re paying?
Now you also need to look into what areas of your mortgage could increase in some parts of the country. You can expect property taxes to go up on a regular basis while others have more stringent limits. A mortgage payment includes your principle interest, taxes, and insurance. Your principle will not change for the life of your loan. Interest, unless you’re in an adjustable rate, mortgage will not change for the life of your loan taxes. This can change each year, but it’s something you’ll pay monthly into an escrow account. Some areas have limits to how much this can change each year. Others, not so much. You may be reassessed every two years and need to pay the property taxes on that new rate, or like in California, it’s limited to no more than 2% more each year, so it’s a very minimal increase.
Insurance
Insurance can almost be a wild card in some areas. This doesn’t change much in other areas like parts of Florida or areas with high prevalence of wildfires. We are seeing these numbers double or triple.
Utilities
Now, when you do buy a home, typically it’s going to be larger than an apartment. What that means is that your utilities will likely cost more, but as with a rental, you are typically paying utilities anyways. Any kind of increase in cost is going to be similar for a home versus an apartment, but the numbers might just be a bit larger; if your electric bill in an apartment is around $100 a month, it might be $200 in a home. If those go up 50%, it’s still going up 50% for either of them.
So again, there are some variables that do increase on a home purchase, but at the end of the day, they are rather minimal. And when compared to rental, those rental increases go up much faster than a market increase could over a term. And one of the things that a lot of people forget about is that after 30 years, once you’ve paid your loan off, you are no longer paying your principle or your interest. You just need to pay taxes and insurance. And many times, that’s only about 25% of your normal payment. So if you’re paying $3,000 a month, you’re probably only going to have to pay about a thousand dollars a month in total for your home, for the rest of your life, and that’s quite a deal.
So then let’s continue with the previous idea of buying compared to renting. You need to really think about what changes you’ll be making in your life in the next five, 10, even 20 years that you can work into your budget. There are two major areas to look at here:
- How will your income change over this timeframe?
- How will your expenses change over this timeframe?
Income
If you plan to stay in the same job long-term, have you been (and do you expect to continue) getting regular raises? If you’re in a union or a type of job that has scheduled increases, you should consider how that looks as well. If your job has a lot of variability, such as something in sales, you may want to stay more conservative as you don’t know how the market might change.
If you’ve been working your way up the corporate ladder, adding extra income on a regular basis, and have a long-term career strategy, then you can take that into account. How will your mortgage payment be in three or five years? We see this a lot in the medical and education fields. The first few years tend to be lower paying, but once you hit a certain threshold, your income increases significantly, and that mortgage payment all of a sudden becomes very affordable. But buying a home three years later maybe wouldn’t have been as easy, and that mortgage payment would actually be much more difficult to attain.
EXPENSES
Think about areas that could change: having children, whose expenses will continue to vary throughout their lives; educational costs if you continue with additional certificates, licensing, or continuing education to push your career; and others like these.
Overall, inflation and general cost of goods will always go up, and that should be taken into account. More specifically, f you generally receive a 3% raise each year, that is just keeping up with inflation in most parts of the country; so, your budget would likely end up about the same year over year from what you have left over.
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These are all things to take into consideration and pay careful attention to when you’re making a decision on how much your budget is. These nuances can make all the difference in the end. It’s always important to do your due diligence and research before making any major decisions.