Your first thought, “I want to stop renting and buy a house.”
Second thought, “I wonder how much house I can afford.”
Home affordability, however, is a delicate balance between your personal budget, home prices in your area, what you need out of the house, and your future financial goals. Yes! The goals you have for your future after you buy the home.
With all of these warring priorities, it’s no surprise that a large portion of homebuyers end up over budget. In fact, according to a survey from real estate brokerage Owners.com, 41% of recent homebuyers say affordability would be the biggest issue for people buying a home this year.
In fact, according to the same survey results, every generation spends more on their future home than they intend.
- 46% of millennials went over budget
- 39% of Gen Xers went over budget
- 27% of baby boomers went over budget
But it doesn’t always have to be that hard. And even though going over budget to score the perfect nest is a hard temptation to resist, your financial future could depend on staying on-track with your home buying budget. (And contribute to home buyer's remorse!)
How to set a home buying budget: 4 steps.
Step #1 – Make your wish list first.
Home affordability isn’t just about the list price of a home. The listing price encompasses what you get in a home. This is why I recommend for homebuyers to create a wish list first before they even start playing with the numbers.
Then, separate this “wish list” into two columns: needs and wants.
Often, your needs won’t match up with what’s affordable in your area. In your area, your budget might get you three beds and two baths with no extras, like a basement or pool. This is why it’s important to know first what those non-negotiable items are.
#2 – Find your number, subtract 20%
The old affordability trick of taking your annual income and multiplying it by 3 (or four in some cases) is just that – old. This quick calculation doesn’t take into account the very nuanced details of most individuals’ financial picture.
This type of affordability calculation is also how people become “house poor” – they buy a home solely based on what their income allows, and then have to make a new, escalated mortgage payment. Add bills AND existing debt and suddenly, their discretionary income for fun things like shopping, travel, and eating out shrinks.
I like this home affordability calculator from Credit.com because it asks you for both income and debt information. Then, I recommend taking the number it spits out and subtracting 20% of your take-home income pay from this number.
Ideally, you should only spend 50% on living expenses, 30% on your lifestyle and 20% of your income should go toward debt and savings. (It's called the 50-30-20 budget method) Subtracting 20% from how much home you can afford ensures you’ll be able to afford the home, contribute to retirement, pay your debts, and still hit annual savings contributions – or at least get very close.
#3 – Factor in additional home-buying costs.
Say you want to buy a 3-bedroom/2-bath home for $275,000. It’s important to keep in mind, however, that when you get to closing you won’t just pay the bank $275,000.
There are also closing costs, which are generally between 2-5% of the list price.
Many buyers forget to account for closing costs in the total purchase price. So, using the credit.com calculator again, if I’m approved for $275,000 and I subtract 5% of that number for closing costs, plus I subtract 20% to ensure I can still save, I get an actual home affordability price of $206,250.
#4 – Go back and rework your wish list.
Now that you have a true home affordability number, go back to a home search tool and see how your wish list stacks up against home prices in your area. You may find you’re not able to get a few of the “wants” on your list, but nearly all of your needs.
Maybe you’ll need to look at a smaller, starter home or look outside your preferred area for a bargain. Working with a trusted agent is also important because they are experts in the local market and can help you find the right home for your budget.
The TL: DR
Setting the right home buying budget and buying a truly affordable home not only helps in meeting other important financial goals (hi, retirement). Searching for a home that sits nicely in your existing budget also keeps your day-to-day lifestyle in check.
Because no matter how fabulous your new place is, saying no to brunch because you have to pay your mortgage still sucks. (Need a refresher on what a mortgage actually is? click here.)