For many first-time homebuyers, having a sense of how much mortgage they can handle is a tricky matter. The amount borrowed seems enormous, often the most considerable amount they’ve ever had to face in their lives, but the repayment schedule is very long and the monthly payments seem doable… but, are they?
Many people turn to simple rules and calculations to estimate whether they can afford the best mortgage for them. While these simple rules are convenient, do they really make a lot of sense when the financial landscape changes?
For example, in today’s mortgage world, interest rates are at nearly historic lows. Do the traditional rules and strategies for figuring out if you can afford a house still hold up? Let’s look at a couple of popular rules.
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Twice your annual income rule
One rule often used to determine if you can afford a home is found in The Millionaire Next Door by Thomas Stanley and William Danko. It states that the maximum value of any mortgage should be twice your household’s annual income. For example, if you and your partner together make $100,000, this rule suggests that the maximum amount you should borrow is $200,000.
This rule was initially shared in the 1990s, a decade in which interest rates on home mortgages started out around 10% and gradually declined to about 7% at the end of the decade. Compare that to today’s mortgage rates, which often come in around 3% to 3.5%.
Does it hold up?
In the 1990s, when this rule first became popular, you might be considering a home mortgage at 8% interest. In that situation, if you were making $100,000 a year, you would be able to take out a $200,000 30-year fixed mortgage, which would give you a monthly payment of $1,750.86.
Today, interest rates are around 3.5%. In this situation, if you are borrowing $200,000 for a home on a 30-year fixed mortgage, you would have a monthly payment of $1,181.42. That’s a much smaller monthly payment, one that’s much easier to deal with. A $600 difference in a monthly budget for a household earning $100,000 a year is a pretty big deal. In fact, you could borrow $330,000 on a 30-year fixed mortgage at 3.5% and have the same payments as a $200,000 30-year mortgage at 8%.
Granted, a more expensive home means more expenses than a cheaper home — higher insurance, higher property taxes, more home maintenance costs and higher utilities. But someone following the twice your annual income rule at an 8% mortgage interest rate could afford a somewhat more expensive home at a 3.5% mortgage interest rate, probably somewhere around 2.5 times one’s annual salary. However, this varies so much depending on the interest rate you’re getting that I wouldn’t fully trust it.
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The 25/28/30 rule
This rule has been stated in various forms since home mortgages first became popular, particularly in the 1950s. Rather than looking at your total income, this rule considers the monthly payment. In short, it says that you should only get a mortgage if the monthly payment makes up a specific percentage of your monthly income (or less).
Suppose your household earns $5,000 a month; the particular version of the rule states that you should only get a mortgage with a monthly payment that’s at most 30% of your income. For this example, you should cap your mortgage at a level that offers you a $1,500 monthly payment.
Does it hold up with low interest rates?
With this rule, if you hold the monthly payment the same but lower the interest rate, you can afford a much bigger mortgage. For example, at 8%, a $1,500 monthly payment would accompany a roughly $180,000 mortgage, while at 3.5% interest, a $1,500 monthly payment would allow you to have a $260,000 mortgage.
The problem is that with a bigger mortgage comes many other expenses. While you can get a bigger house for the same mortgage payment when interest rates are low, the actual cost of your house will be much more. You’ll have higher home insurance, higher property taxes, higher utilities and more maintenance costs, which will eat up a larger portion of the remainder of your living expenses.
When interest rates are high and you’re locked into 30% of your monthly income for your mortgage payment, the other expenses can account for another 20% of your monthly income, leaving you 50% for taxes and living expenses. However, when interest rates are low, you can buy a bigger house and still have a mortgage payment that’s only 30% of your income, but now that bigger house is gobbling up another 30% of your monthly income, leaving you just 40% for taxes and living expenses.
As interest rates go down, the percentage of your income that you devote to a monthly payment needs to also go down to accommodate the higher expenses of a bigger home. The exact amount depends a lot on the state of your local housing market, too.
Personal finance rules are never universal
The big lesson we can learn is that one size doesn’t fit all. Whenever you have a simple financial rule to follow, it relies on assumptions that might be true at that exact moment but are susceptible to change with time. The cost of houses might rise faster than inflation. Property taxes might go up faster than inflation. Interest rates might change, too. Those factors are baked into that rule, so when those ingredients change, the rule itself needs to change, too. It doesn’t hold true.
So, what can you do? One strategy is to use a good mortgage calculator. These calculators let you easily figure out what your monthly payments and other expenses might be based on the cost of your home. You may need to find additional information, like property tax and mortgage rates in the area where you’re buying, but this will give you real numbers to work with.
Another strategy, particularly if you’re a first-time homebuyer, is to trust your lender’s suggestions. Most lenders have specialists who work with first-time homebuyers and understand people’s financial realities in that situation. They typically only preapprove mortgages for amounts that borrowers can easily handle, as they have no interest in you being unable to afford your mortgage, either.
Finally, knowledge is key. The more you learn about home mortgages, the easier it will become to assess what you can afford without relying on simple rules that don’t really work.
Now, here’s the tricky part, and it’s why I tend to lean toward the first rule regardless of interest rate.