How Much Can I Afford to Spend on a House?

Reader Question: “My husband and I plan to buy our first house later this year or early next. I was wondering how much I can afford to spend on a house for the first time. How does a mortgage lender decide what I can afford to pay for a home?”

You’ve touched on an important topic, and I’m glad you’ve asked this question. Let me start with the second part of your question, and then I’ll expand on the topic. In reality, a lender cannot tell you what you can afford to pay for a house. They can only tell you the maximum amount for which you are qualified to borrow. Note the difference here, because it’s an important one.

Being qualified for a certain loan and being able to afford it are not the same thing — that’s why we have so many foreclosures across the country right now. People got approved for mortgages that were too big for them.

Whenever I say this to home buyers, their next question is usually something this: “But why would a bank approve me for a risky loan that might be too big for me down the road?” They do this because of the secondary mortgage market (i.e. Freddie Mac and Fannie Mae). These corporation buy loans that are made by primary lenders. So, in essence, a primary lender like Citi or Wells Fargo can make a loan and then sell it off to somebody else. Goodbye risk! They make the profit, and they sell off the risk to somebody else.

But that’s another story entirely. Let’s get back to the question at hand. How much can I afford to spend on a house / mortgage? We have addressed the first step already. Don’t let a lender tell you how much you can afford to pay. They are not your financial advisor. They are in the business of making money. They do not care about your financial well-being or your quality of life. Sorry, but that’s just the reality of the relationship.

Figuring Out What You Can Afford to Spend

Here’s the key to figuring out how much house you can afford to buy. Measure your income and your expenses at the monthly level, and then see what you have left to put toward a mortgage loan. Here’s how you would do this:

1. Add up your monthly expenses (groceries, car payments, savings, entertainment, etc.).
2. Leave your monthly rent payment off the above list. That expense goes away when you buy.
3. Next, write down your monthly gross income. This is your take-home pay, after taxes.
4. Subtract your monthly expenses from your monthly income. Circle the resulting number.

The number you circled is what you have available to put toward a mortgage loan. You certainly don’t want to use that entire leftover amount for a mortgage payment — that’s stretching yourself too thin. But at least you’ll know the maximum you can afford to spend on a house (through monthly payments).

I would reduce that number you circled by 10% to 15%, so that you still have money left over each month after paying your mortgage. It’s always good to have an “emergency fund” of extra cash on hand.

Here’s an example scenario…

Let’s say I make $5,500 per month after taxes, and I spend about $2,200 per month in expenses. These expenses also include the money I put aside for savings each month, which is an important point. I subtract my expenses from my gross income, and that leaves me with $3,300. I would not put this full amount toward a mortgage loan, and a lender probably wouldn’t approve me for that much. It’s too much of a mortgage in relation to my income. Personally, I would reduce this remainder by at least 15% to get a more comfortable monthly-payment limit. That would take me down to a payment cap of around $2,800. That’s still a bit high, if you ask me, but we are now reaching a more realist number.

In the above scenario, I can afford to spend around $2,500 per month on my house payments. Most importantly, I would not be “house poor” — I’d still have money left over each month for other important things.

Does this mean that a lender will approve me for a mortgage loan with payments in this range? Maybe. They might approve me for more, or they might approve me for less. If they approved me for a higher amount, it should set off red flags in my brain. Sure, they think I’m approved for that amount — but it doesn’t mean I can actually afford to buy a house at that price. How do I know this? Because I’ve already done the math, created a budget, and established my own maximum payment size.

This is what you should take away from this lesson. You need to determine how much you can afford to spend on a house before you even talk to a lender. You need to know where your financial comfort level lies, and you need to stay within those limits.

Time for Some Tough Love

I’ve long had the opinion that home buyers have a rosy picture painted for them, courtesy of mortgage lenders and housing advocacy groups. They talk about the concept of universal home ownership, where every buyer can qualify for a mortgage loan to get a house. I don’t know what fantasy world these people live in, but that’s not how it works in the real world. Home ownership is something you have to work toward. You must earn the privilege by being financially responsible, saving your money, etc.

The same goes for making your mortgage payments. You are the responsible party here. If you knowingly spend more on a house than you can afford, and you end up in a foreclosure situation down the road, you will have nobody to blame but yourself. Don’t blame the bank. Don’t ask the government (i.e., taxpayers) to come bail you out. Just accept that you made a gamble and lost.

Of course, all of this hardship is easy to avoid. You simply have to be smart and buy within your financial means. Use the steps I’ve outlined above to figure out how much you can afford to spend on a house, and stay within that budget!