“How much house can I afford?”

“How much house can I afford?” Answering this question correctly is one of the keys to building a happy, wealthy life. Unfortunately, there's a vast housing industry in the U.S. that's geared toward providing the wrong answer.

You see, housing is by far the largest expense in most people's budgets. According to the U.S. government's 2016 Consumer Expenditure Survey, the average American family spends $1573.83 on housing and related expenses every month. That's more than they spend on food, clothing, healthcare, and entertainment put together!

Too many folks struggling to make ends meet focus their attention on fine-tuning their budget. They try to save big bucks by clipping coupons, growing their own food, and/or making their own clothes. While there's nothing wrong with frugal habits — I applaud everyday thriftiness! — all of these actions combined won't (and can't) have the same impact on your budget as keeping your housing payments affordable.

Part of the problem is what I call the Real-Estate Industrial Complex, each piece of which has a vested interest in convincing consumers that bigger, more expensive homes are better. Real-estate agents, mortgage brokers, home-shopping shows, and glossy magazines all encourage folks to buy at the top end of their budget. But buying at the top end of your housing budget is dangerous.

Buying a home is a huge decision, financially and otherwise. If you're going to purchase a place, it's important to know how much house you can truly afford.

How much house can you afford?

Debt-to-Income Ratio

Economists have used decades of financial stats to create computer models to predict how much people can afford to spend on housing and debt. Banks use these models to figure out how much they think you can afford to spend on housing.

Traditionally, lenders use what's called a debt-to-income ratio (or DTI ratio) — a measure of how much of your income goes toward debt every month — to estimate how much you can afford to pay for a home without risk of defaulting. This might sound complicated, but it's not.

To find this ratio, divide your monthly debt payments by your gross (pre-tax) income. So, for example, if you pay $400 toward debt every month and you have an income of $4000, then your DTI ratio is 10%. If you pay $800 toward debt on a $4000 income, your DTI ratio is 20%. The lower your debt-to-income ratio, the better.

Banks and mortgage brokers look at two numbers when deciding how much to loan:

  • The front-end DTI ratio (sometimes called the housing expense ratio), which includes only your housing expenses: mortgage principle, interest, taxes, and insurance.
  • The back-end DTI ratio (also known as the total expense ratio), which include all of the above plus other debt payments like auto loans, student loans, and credit cards.

The key thing to understand about debt-to-income ratios is that they're used to estimate the lender's risk, not yours. That is, your mortgage company uses them to check whether they think you'll be able to make the payments — not whether you can comfortably make the payments.

If you want room in your budget for fun, you should opt for a lower debt-to-income ratio than your real-estate agent and mortgage broker say you can use.

If you're a money nerd, you can read more about debt-to-income ratios at Fannie Mae's website.

How Much House Can You Afford?

During the 1970s (before credit-card debt was common), DTI wasn't split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance costs were less than 25% of your income, people assumed you could make the payment.

This is still an excellent rule of thumb: Spend no more than 25% of your budget on housing. (In fact, this is the number that money guru Dave Ramsey advocates.)

That said, debt-to-income guidelines have relaxed over the years.

  • When my ex-wife and I bought our first home in 1993, our mortgage broker told us that our front-end DTI ratio had to be 28% or lower, meaning we couldn't pay any more than 28% of our gross income toward housing. The back-end DTI ratio was capped at 36%, which meant that our housing expenses and other debt payments combined couldn't be more than 36% of our income.
  • When my ex-wife and I bought a new home in 2004, the accepted DTI ratios had grown by 5%. “That 28% figure is outdated,” we were told. “Most people can go as high as 33%.” The back-end ratio had been raised to 38%.
  • According to the Fannie Mae website, in 2018 maximum back-end DTI ratios are up to 45% (and sometimes even 50%). These numbers are insane. Nobody should be spending half of their gross income on debt — not even mortgage debt! That's a recipe for financial disaster.

Here's a little table I whipped up to show what sort of housing payment you'd be looking at based on your pre-tax income (the left-hand column) and various debt-to-income ratios (the header row):

Debt to Income Ratios for various levels of income

A 5% increase in your debt-to-income ratio might not seem like a big deal. But when you're talking about a house payment, it's huge.

In 2016, the average American household earned $74,664 before taxes. Using this, a 5% change would be $3733.20 per year or $311.10 per month. Many folks lost their homes during the housing crisis because they took on mortgage payments that were just $300 more than they could afford each month.

Real-Life Examples

When my ex-wife and I moved in 2004, our housing payments went from around $1200 per month to roughly $1600 per month. This $400 per month difference was enough to make me panicked about money.

Similarly, my youngest brother made the mistake of believing the banks when they told him he could afford a big housing payment. He could at first. But when the financial crisis hit in 2008 and 2009, he was screwed. Because he'd bought at the top end of his budget, when his income faltered, so did his ability to pay his mortgage. He lost his home to foreclosure.

For the most part, banks are happy to lend you as much money as you want. (Within reason, of course, and if your credit is good.) They're not going to stop you from taking on more debt if their computer models say you can afford it. It's up to you to exercise caution.

In The Automatic Millionaire Homeowner, David Bach writes [emphasis is mine]:

You should generally assume that the amount the bank or mortgage company will loan you is more than you should borrow…Don't fool around with this. Do the math. Be realistic about your situation. Don't pretend you're in better shape than you are.

Remember: Nobody cares more about your money than you do. Your real-estate agent, mortgage broker, and bank all have a vested interest in encouraging you to buy as much house as possible — their incomes depend on it. Listen to what they have to say, but make your decision based on what's best for you.

Playing House

If you think you're ready to buy a house, take a few months to do a trial run. In The Money Book for the Young, Fabulous, and Broke, Suze Orman says that you should “play house before you buy a house”. I like this idea. Here's how it works:

  1. Figure out how much you think you can afford to pay for a home every month, including mortgage and maintenance. Let's use $1750 as an example.
  2. Subtract the amount you're currently paying for housing. If your rent (or current mortgage) is $1000 per month, you'd subtract this from our hypothetical $1750 to get $750 per month.
  3. Open a new, separate savings account. On the first day of each of the next six months, stick $750 into this account.

This exercise lets you experience what it's like to make a higher housing payment. If you can't make these numbers work, Orman says you need to wait:

If you miss one payment, or if you are consistently late in making the payments, you are not ready to buy a home. If you can handle the extra payments, then you've got the thumbs-up to start looking for a home to buy.

Generally speaking, once you've saved 20% for a down payment and you can afford monthly mortgage payments, you're ready to start looking for a home. Yes, you can buy a home with a smaller down payment — I bought my first place with a 2% down payment! — but it'll cost you in the long run. You'll need to carry private mortgage insurance (PMI), you'll pay more in interest, and you could put yourself in a position where you can't afford to keep your home.

Buy only as much home as you need

The Bottom Line

Homebuyers are often told to “buy as much house as you can afford”. But the problem with this advice is that it leaves you without a buffer. What if you lose your job? What if you're forced to sell your home after housing prices have dropped?

Instead of buying as much house as you can afford, buy only as much house as you need. Think of conventional debt-to-income ratios as ceilings, not targets.

Give yourself margin for error. Instead of basing your home-buying budget on a 36% front-end DTI ratio, consider dropping that to 28%. Or, better yet, 25% (just like the olden days!).

If you have an average U.S. household income of around $75,000, a 36% DTI ratio would lead you to budget $2250 per month for housing (assuming you have no other debt). If you were to go with a more conservative 25% DTI ratio, that budget would be $1563 per month. That's a savings of $687 per month — over $8000 per year! Just think: What could you do with a chunk of change like that?

Another way to create a buffer is to base your budget on your net (take-home) pay instead of your gross pay. Or, if you're in a relationship where both partners work, run the numbers for only one of the two incomes.

No, you won't be able to afford a big mortgage if you do what I'm recommending. But you know what? You won't feel pinched by your mortgage payments. And you'll be at much less risk the next time the housing market implodes. Best of all, you can plow all of the money you've saved on housing into a building a ginormous wealth snowball!

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Adam
Adam
2 years ago

Testify! My wife and I have seven years in a 1100 ft^2 craftsman from 1921. It’s everything we need and nothing we don’t. We might blow half a hundred grand on a full-width dormer across the back for a second bathroom and real closets for the two bedrooms, but that’s just for the sake of hosting in-laws (or an increasingly hypothetical kid). As long as existing space is livable, it’s wonderful how much we don’t need.

Doug
Doug
2 years ago

I guess one clarification is Dave Ramsey recommends no more than 25% of your take home pay; not gross income. It is interesting to see the creeping up of allowed ratios over time.

Marvin
Marvin
2 years ago
Reply to  J.D. Roth

I think you went the wrong way for Ramsey. 25% of take home pay would be less than 25% of gross pay.

Accidental FIRE
Accidental FIRE
2 years ago

I see the 33% number waaay more often than the 25%. I also think 33% is way too high. But, depending on where someone lives and their income, they might not be able to have options to only spend 25% or less of their budget on a house. There might be nothing available except a studio apt. In those cases geoarbitrage (or renting) might be the best option.

Jason@WinningPersonalFinance
2 years ago

I think the first step before even looking at the housing % of your income is to figure out your wants and needs for your home are along with identifying your other goals. My wife an I purchased a house based on about 11% of our gross income at the time. It met all of our needs and had some of the stuff we wanted. While our home is not glamorous, the lower cost has allowed my wife to leave her job and still keeps us in a position to save for financial independence. Where you live is only one… Read more »

Jon
Jon
2 years ago

We’re at 13.5% on the ratio for a 1600sq ft house on a half acre in the Puget Sound area. Keeping things reasonable has allowed so many other benefits like maxed 401k and Roth. The extra money not tied up in a big house has the ability to grow and grow. I work with a lot of “typical” Americans that spend way too much money on houses and toys.

Danielle
Danielle
2 years ago
Reply to  Jon

Agreed! We’re at 10.47% just outside of Boston, and are also able to max out our 401k and Roth accounts. We’re also able to spend on what matters to us – which includes at least one international vacation per year.

Steveark
Steveark
2 years ago

As I’ve only had this one same house for decades I don’t have a lot of experience with house payments but my mortgage was only 14% of our family take home income when we bought the place. By the time we paid it off very early it had dropped to single digits of my take home pay. Having a small house payment and never borrowing to buy cars or anything else made saving and investing very easy.

Hans
Hans
2 years ago

When my wife and I were buying our house, one of the mortgage brokers we talked to was shocked at how “little” we wanted to borrow, encouraging us to borrow *twice* as much as we wanted with the justification that we could hold on to more of our down payment and “stay liquid”.

Instead, our mortgage payment is now lower than many of my friends’ car payments, and we can feel secure about our housing situation regardless of what comes our way.

Amanda V
Amanda V
2 years ago

I would look at how much house you need and how much in your budget you can reasonably afford. According to this, we could afford a million dollar house. But since both of us are working, our daycare payments are as much as our mortgage. No million dollar house for us, haha.

Jo
Jo
2 years ago

Greetings from the UK, a nation obsessed with housing and house prices! I solved my personal house-buying / “how much debt” issue by buying an 1880s property split into 3 apartments. It seemed to give a good combination of short-term financial stability (rent coming in to offset most of the mortgage interest) and long-term flexibility (we could always knock it back into one property in the future). 15+ years later, the mortgage is long gone and we’re sticking with the apartment we’ve got plus the income stream (we see it as living in an apartment with the added benefit of… Read more »

sequentialkady
sequentialkady
2 years ago

Hub & I purchased less house than we could afford. One of the smartest things we ever did; it allowed us to avoid so much *extra* debt because when something expensive went wrong, we didn’t have to go into additional debt to fix it.

S.G.
S.G.
2 years ago

Those numbers are including escrow, right? We had a great real estate and mortgage broker combo for our first house (we used the same team for our second). When we went to buy a house we were both making exactly the same amount of money. We told them we wanted to qualify based on one salary, and the mortgage broker wrote her pre-approval letter for the number we told her our limit was (probably half of what we could have been approved for, even on one salary). When we made an offer on a house that was a couple thousand… Read more »

dlk
dlk
2 years ago

25%?

How about 12.5 % then pay the difference toward your mortgage every month.

We paid our home off in just under five years with this strategy.

Just sayin…

Sara
Sara
2 years ago
Reply to  dlk

I agree with this! We are doing something similar. We have a 30 year mortgage but are paying it regularly like a 15 year (which brings us right to 25% of take home). We also throw extra at it when we get bonuses or a little income from a side gig. This way if stuff ever hits the fan we can stop paying the extra and and have a very manageable payment. We estimate that we’ll pay off our house between 8-12 years if everything goes according to plan.

lmoot
lmoot
2 years ago

My PITI is currently 11% of net income, and 8% of gross. My income has doubled since I bought the house 9 years ago. But on the flip side, I’ve spent $40k on renovating and repairs. I didn’t want to be house poor and I wanted my home to be an investment. It also helped that I purchased my house when I got my first full-time job and my income was at its lowest. As much as I am enamoured with all things residential real estate, I would never give quality of life up to sit in a house. When… Read more »

Adam
Adam
2 years ago

I definitely like 25% as a good baseline, allowing that to go higher for higher income families, and lower for lower income families.

Kate
Kate
2 years ago

When my husband and I bought our first home at the height of the market in 2005, I remember the bank telling us we could afford around $350,000 mortgage loan (which mean an even higher housing price). I divided whatever the mortgage company would pre-qualify us for in half and said we’d stick below $200,000k. We still lost over $60,000 on that home, paid tons to sell it, but next time around we did the same thing. We were told $450,000+ the second time, and I kept it to $235,000. I always considered keeping our housing costs (with utilities) around… Read more »

Sandi Kay
Sandi Kay
2 years ago

This 25% figure works well with the Balanced Money Formula – e.g., no more than 50% of your income to be spent on needs.

We spend 20% gross on the house PITI (with a 15 year mortgage), 20% on taxes (federal & state), and 20% on retirement savings each month. Everything else is a rounding error. :-0

Bernard
Bernard
2 years ago

I’m a newcomer here, and that’s the first blog I read. On principle, you are correct, of course, but let’s not forget that there are vastly different areas throughout the country. (I know what Mr. Ramsey says.) We don’t have to talk about the cost of living in Silicon Valley, or the Hamptons, or even Santa Barbara, where it’s silly expensive. But there are many other areas where the cost of living is quite high. Case in point: my own. I live in Ojai, California, one of the nicest areas to live anywhere on this planet (I lived in 7… Read more »

Naveen
Naveen
2 years ago

As you correctly say, DTI is for the bank. As a homeowner it would be prudent to add property taxes, insurance, HOA, any maintenance costs into your total spend on housing. Here in the Bay Area, CA, property taxes could account for 25% of total housing spend. In our case, $3500 in Principal and interest, $1500 for Tax, HOA and insurance. I have had mortgage brokers conveniently not include these costs when talking about affordability. What is crazy is many of my friends rely on their ‘Guaranteed’ bonuses to pay off the property tax.

Faith @MuchMoreWithLess
Faith @MuchMoreWithLess
2 years ago

So agree about not borrowing to the max. When my husband and I bought a home together, we worked out how much we thought we could afford based on one salary, as I was pregnant and not 100% convinced I would return to my office job. The mortgage broker said we could apply for a frighteningly large mortgage, but we stuck to our guns. Meant I had the freedom to go freelance, and earn less while our children were young, without being chained by huge mortgage payments to a higher paying job. One caveat: consider property expenses beyond the mortgage.… Read more »

Marleigh
Marleigh
2 years ago

We learned our lesson after losing our house to foreclosure during the Recession. When we finally were able to buy another one, we decided to go as affordable as we could. We settled on a house that costs the same as a luxury SUV and with our low note, (less than 500.00) are able to pay more into it with the hopes of paying it off in five years. And good thing too because 3 days before signing the papers, I started feeling strange and a week after moving in, I was definitely sick. A few weeks later, I was… Read more »

DeShena
DeShena
2 years ago

Hi JD,
OMG! It is scary how realtors and banks prey on people by telling them they can afford ridiculous mortgage payments. And unfortunately, so many people fall right into the trap. Mostly because we have been programmed to believe that bigger is better. When we need to focus more on living comfortably and with less stress.

phil wolf
phil wolf
2 years ago

Housing anymore cost-wise seems to be taking a back seat to school loans and kids as major expenses. When my wife and I bought out house we used the percent capped by the FHA. We sort of fell into a small home. Kids hoped for but never had and no school debt helped us financially. My job started at low pay but with the help of the union and continuous employment has gotten much better. Now with fingers crossed that they don’t screw with Social Security and Medicare (in a bad way) it’s pretty smooth sailing. Oh and living in… Read more »

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