This question is often answered by lenders with rules of thumb related to both housing debt and total debt. For example:
- Monthly payments for principal, interest, taxes and insurance should not exceed 25 to 30 percent of total monthly gross income.
- Monthly payments for all debt should not exceed 36 to 42 percent of total monthly gross income
- Total house price should be between 2½ and 4 times your annual salary.
There are two problems with the rules of thumb:
- They are maximums for the person who wants to stretch and afford as much house as possible
- They do not account for your specific spending situation
The rules of thumb provide for at least a bare bones standard of living. They also factor in non-mortgage debt such as auto and student loans. But the rules of thumb do not on a case-by-case base account for your individual needs and circumstances, such as:
- The need to fund future college expenses
- Do you need to increase contributions to retirement plans?
- Your desire to fund children’s activities, daycare, or private school
- Your particular desires for leisure and vacation activities
- Changes in work income, for example a spouse stopping work to have children
- The need to replace a car in the near future
- Ongoing replacement of household furnishings
- Setting up a budget for future big-ticket items like a new roof
The best way to figure out how much house you can afford is to develop a personal spending and saving plan for all your lifestyle expenses before you start house hunting. Such a plan starts with your monthly paycheck income, and considers:
- Normal monthly expenses like food and clothing, auto expenses, gifts and charitable contributions, medical expenses, etc.
- Irregular expenses such as car insurance payments
- Expenses related to your personal lifestyle needs, as well as medium and long-term goals, such as outlined above.
- Non-mortgage housing expenses including taxes, insurance, utilities and maintenance
The amount left after accounting for these is what you can budget monthly for the principal and interest payment for the mortgage. That in turn will tell you a realistic total dollar amount for a mortgage, depending on the interest rate and how long the mortgage is. If you add the total mortgage amount to your down payment you will have an estimate of how expensive a house you can purchase.
Purchasing a house is a major expense, and a big part of the family budget. Buying too much house is also one of the major reasons families get into trouble financially, or at least struggle to do all the things they might like to in addition to just living in the house.
Do some thinking about your long-term lifestyle goals and aspirations, along with the inevitable irregular expenses. It will help you at least sketch out an effective, workable spending and saving plan that will put the house needs into perspective with all your spending needs, now and in the future. This will give you a much better idea than standard rules of thumb about just how much house you really can afford.