How much house should you buy? This is a very different question from how much house can you buy.
Most serious house buying adventures begin with getting pre-approved for a mortgage so you know how much money the bank is willing to lend you. The mortgage broker or lender looks at your income and existing debts and savings to calculate how much they are willing to lend you.
However, just because you technically can afford a house payment for the size or mortgage they approve you for, that doesn’t mean you should buy a house that costs as much as they are willing to lend.
It should be noted that a mortgage broker is not a fiduciary. In other words, they are not required to act in your personal best interest. They do have guidelines they have to follow and some mortgage brokers are surely good people who may offer genuinely good advice – but they are not required to.
Keep all financial goals in perspective
Lenders look at your income before taxes. If you and your spouse are applying together, they look at your combined income.
They aren’t considering that you want to max your retirement plan contributions. Or if you want to utilize a health savings account. Or if you plan on having a child after you move in and therefore will either have significant child care expense or will be dropping one income for a parent to stay home and raise the child.
You should look at your goals and your long term expected take home pay after other savings and do your own math to see what kind of mortgage payment fits within your other life goals and find out how much house you can really afford.
Do you want to have this house paid off before you retire? If so, when do you want to retire? Are you looking at retiring 15 years from now? If so, you should probably consider a 15-year mortgage to force yourself to stay on track to hit that payoff date. You can also do a 30-year mortgage and either make extra payments along the way or you may plan to focus on investing as much as possible and once you are on the cusp of being able to retire, aggressively pay off the mortgage over a couple years.
Can you afford a 15-year mortgage payment while still meeting your other savings goals? If you are going to do the 30-year route and aggressive pay off at the end, how long will it take you to do that aggressive payoff? For example, if your loan balance is projected to be $200,000 10 years from now, and your plan is to pay it off over 3 years, that would require $5904 per month – a difficult task for most. On the other hand, if you bought a more modest house and only owed $75,000 after 10 years, that would be more like $2214 per month which is a lot more attainable for most extreme savers with good income.
(using 4% rate for 30-year examples)
Windfalls and down payments
You generally always want to do at least a 20% or even 25% down payment. Sometimes a 25% down payment will get you an even lower interest rate. If someone has been diligently saving their down payment for years, they probably are also less likely to splurge and over extend themselves.
However, if someone comes into money, such as an inheritance or a large bonus or stock options at work, they may feel inclined to use that full bonus as just a 20% down payment on a large house that may jeopardize their retirement plans.
Taking a windfall and multiplying it by 5 (20% x 5 = 100%) to set your home shopping budget such as: $100,000 x 5 = $500,000 potential budget, with a $400,000 mortgage and a $1909 payment before taxes/insurance for 30 years, ouch. And most people can forget paying that off over even 5 years. After 10 years, you would still owe $315,136 and it would take a monthly payment of $5803 over 5 years or $9304 over 3 years to pay it off. A more realistic scenario would be to try to downsize to a smaller house.
Instead, consider that a $100,000 down payment on a modest $200,000 house leaves you with only a $100,000 loan. Even for a 15-year loan at 3% that would be $690 per month. On a 10-year loan, that would still only be $965 per month.
Sure, you won’t have a McMansion. But think how rich you’ll feel by having so much more money each month to invest in the stock market, take family vacations, pay for lessons for your children, save for college, etc.
When you are approaching retirement, it will be that much easier to pay off your house right before retiring.
Just because a lender is willing to lend you a lot of money for your house purchase doesn’t mean that is what your budget should be. It is easy to be tempted to spend more on a house. Almost everyone involved in the home sales process wants you to spend more – realtors get a % commission on the sale, lenders often have sales goals to meet, insurance policies on bigger houses cost more, etc. Everyone wants you to spend more, not less. And it’s easy for egos to get involved as well.
Ignore all of that. Buy a house that is modest relative to your finances and keep your other priorities in mind.