Here’s the rule I use to determine how much house you can afford based on your income – let’s call it to the 2x income rule. Simply, you should only spend two times your annual gross income on a house. I’ll discuss some other financial rules for home buying below, but this is the most simple.
How much house can you afford based on your annual salary?
$25,000 a year salary = $50,000 house
$50,000 a year salary = $100,000 house
$100,000 a year salary = $200,000 house
$200,000 a year salary = $400,000 house
This may seem low to some people, but if you want to control your money, this is a great way to do it. It’s easy to get sucked into spending the bank pre-approved limit which is usually much higher, but they don’t have all of your best interests in mind.
In addition to the 2x annual income rule, you should also try to pay 20% down and use a 15 year fixed loan. Easy as that, right? Of course not, but this will at least give you a guideline to think about.
We bought our first house with a 30 year loan and didn’t pay 20% down because we wanted to use our extra cash for a much needed renovation, but we did stay within the 2x income rule. The only way we could get into the neighborhood we wanted was to do it this way. I know, excuses, excuses, excuses. However, from here on out I promise to use the 20% down payment rule and hopefully pay for future houses with cash!
Today’s mortgage rates are incredibly low so it makes mortgages more affordable. Let’s see how it’d look if you followed this rule to home buying across multiple interest rates:
|Annual Income||Mortgage Amt||3%||5%||8%||18%|
|$ 25,000||$ 50,000||$ 345||$ 395||$ 477||$ 805|
|$ 50,000||$ 100,000||$ 690||$ 790||$ 955||$ 1,610|
|$ 100,000||$ 200,000||$ 1,381||$ 1,582||$ 1,911||$ 3,220|
|$ 200,000||$ 400,000||$ 2,762||$ 3,163||$ 3,822||$ 6,441|
Remember, the mortgage amounts listed above don’t include all of the other housing expenses – insurance, property tax, etc – which can increase the payment about 20-30% depending on where you live. Also, you’d add your down payment amount on top of the total mortgage amount listed above.
It’s incredible how much more affordable housing is with low interest rates… I still can’t imagine how crappy it would’ve been to go through the early 80s when rates were in the high teens! The 2x income rule for buying a house would probably have to go down to 1x!
The monthly mortgage payment ranges right around 30% of total monthly net income when using the 5% interest rate. A 3% rate would take you closer to 25% of your monthly take home pay. The 2x annual income rule keeps you in a pretty comfortable range where you won’t be overspending on the house.
That brings us to the next set of financial recommendations for how much house you can purchase. Mortgage lenders typically use the 28/36 ratio rule to determine how much mortgage you can afford. Basically, they look at your monthly gross income and want to keep you from spending more than 28% on the total monthly house payment – including insurance and property taxes.
The 36% rule takes a look at your total monthly debt and says you shouldn’t spend more than 36% of your monthly income on all of your debt combined. What does this do the income ranges we were looking at earlier? Based on your monthly gross income, you could spend this much on a monthly mortgage payment using the 28% rule:
|Annual Income||28% rule|
As you can see, this rule allows you to spend more on a monthly mortgage than the 2x income rule. If you add in the property tax and insurance to the 2x rule it’s a little closer, but 2x keeps you more in line with what you should be spending.
Based on that assessment and the current interest rate environment, I’ll stick with recommending the 2x annual income rule for home buying. What do you think? Have you stayed close to that rule?
One other thing, if you’re buying a car, remember to use the 20% rule! Do you agree with the 2x income rule to determine how much house you can afford based on income?