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What is the Maximum You Can Afford?

Saving for a (2).pngSaving more can help you buy faster, but you’ll still be limited by this “magical” number

There are homes out there that you think you can probably afford and some that you just know you definitely can’t. But where exactly is the line that separates them?

If you’re the lucky one who won the lottery or got a significant inheritance from a rich aunt (cha-ching!), then you likely can afford a big mansion. You’ll still have to pay for the maintenance, utilities and taxes of such mansion, but hey, so does everyone else.

You might think that if you save more money now, then you’ll be able to buy a more expensive home… well, not quite. Your savings will affect “how fast you can get there”, while the money you make every month will affect “what you can buy”.

For us normal working people, there’s a “magical” number that will dictate what we can afford:

28%.

Here’s the deal: assuming when the time comes for you to make your home purchase, you’ll be putting some money as down payment for a loan and finance the rest. The thing is that financial institutions will often apply what’s known as the “28/36 rule”, meaning your housing costs should not exceed 28% of your income, and your total debt payments (student loans, etc) should not exceed 36% of your income.

They’ll typically count the mortgage principal (P) + interest payment (I) + property taxes (T) + home insurance (I) in the math (PITI). Sometimes they might also count homeowner’s association (HOA) fees and private mortgage insurance (PMI), if you’re paying any of those. Here’s an example:

Suzanne works as a Registered Nurse making $78,000 a year in Renton, WA. That’s $6,500 a month, so she shouldn’t exceed 28% = $1,820 in her recurring housing costs. With $1,820 a month, what home can she buy?

The math is kind of complicated to do by hand, so let’s just skip to the result for a 30-year, 3.75% rate loan, 20% down payment, 1% in property taxes, $20/$100,000 home insurance: $384,107.

That’s with the lender not requiring any PMI payment since she would be putting 20% in down payment. If she tries to buy a home more expensive than $384,107, her monthly payment will be higher than $1,820 (therefore higher than 28% of her salary) and she likely won’t qualify for a loan.

But, what if things are a little different?

If her salary increases from $78,000 to $84,000, the maximum price she can afford increases to $413,654.

If the rate on her loan is 4.00% instead of 3.75%, the maximum price she can afford drops to $375,052.

Paying the maximum you can afford on a home isn’t necessarily the goal of most people, but knowing what the maximum is can be helpful in figuring out your realistic goals and how you plan to get there.

We have put together a calculator in an Excel spreadsheet that you can use to figure out the answers above for your own numbers. Check it out!

NEXT: Part 2: High savings “diet” for down payment

 

 

Ricardo Oliveira

Written by Ricardo Oliveira

Ricardo is a software engineer at Faira (and also the first employee!)

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