Personal Finance 101: Buy a Home You Can Afford

I am here to help Millennials make sense of what financial advisors suggest when it comes to buying a house, and figuring out just how much you can afford.

How Much House Can I Afford?

First off there is the 50/30/20 Rule, which states that 50% of your monthly budget should go towards essential living expenses (housing, transportation, food, insurance, heat/water, etc.).

30% should then go towards your more personal items, like “wants”. These are items that you could probably do without, but really want in life; like cable, coffee, dining out, entertainment, travel, etc.

The remaining 20% should go towards debt repayment and savings, short- and long-term goals like emergency fund and retirement, respectively. Obviously the more debt you have the harder savings becomes. That is when you may have to shift your 30/20 plan so you ensure you are paying yourself enough first.

Getting back to just how much house you can afford and the 50% rule. More specifically, financial advisors strongly encourage you to keep your mortgage payment to 25% of your take home pay. Speaking from experience, I completely agree with this. When your mortgage payment equates to 25% or less of your take home pay, its amazing how much money you are left for savings and other “wants”.

Mortgage Payment Calculator

Let’s pretend we have a Millennial couple making $100,000 annually as a household. If they follow the 25% mortgage affordability calculation, they would want to stick to a payment that is approximately $2,000 per month. Based off a 3.7% APR on a 30-year fixed, assuming at least a 5% down payment of $16,000, they could afford a $350,000 house.

Now, let’s get even more conservative. A lot of financial advisors would go one step further and suggest you only spend 25% of your monthly income AND get a 15-year fixed. This will help you tremendously, long-term, at achieving wealth and financial independence (because you would have a paid for home after only 15 years). And the amount you save on interest payments alone is remarkable, but more on that later.

Our same Millennial couple can afford a $350,000 home on a 30-year fixed. However, if they did a 15-year fixed they would only be able to afford a home worth approximately $250,000 (with a 5% down payment equating to $12,000). So $100,000 difference in home value! Trust me, a lot, and I mean a lot of Millennials don’t follow this logic. And it obviously depends on your specific market as well.

Mortgage Payment Calculator: Total Paid with Interest

This next one gets a lot of people. It got me! I don’t think anyone pays attention to just how much a house will cost them over the life of their loan when you factor in total paid with interest.

For example, our Millennial couple who bought the $350,000 house, with 5% down, would end up paying nearly $558,000 after their 30-year term is up. So that $350K house actually costs them $200K more than the purchase price.

Back to our frugal Millennial couple who took the advice of only using a 15-year fixed rate mortgage. The $250,000 house, with a 5% down payment, would end up costing them only $305,000 when their 15-year term is up. That is only $65K more than the purchase price versus over $200K on the 30-year fixed example.

That is why the 15-year fixed rate is recommended by so many financial planners and advisors. It obviously keeps you from becoming house poor and allows you to build wealth quicker. 

Pay Off Your Mortgage ASAP!

At the end of the day, you want to pay off your mortgage as soon as possible. Living rent and mortgage payment free would be a great feeling. If you choose to go the 15-year fixed route its much quicker (twice as fast, obviously), not to mention how much money you save in interest that could be allocated towards retirement, college, or general savings.

According to the Consumer Financial Protection Bureau, 30% of homeowners 65 and older kick off retirement with mortgage debt. Don’t let that be you, Millennials. Pay off your house long before retirement and you could actually retire early because you could then pay yourself your mortgage payment each month and accrue savings rapidly.

Or Do You Keep Investing vs Attacking the Mortgage?

I did some math to see how the numbers compare (mortgage interest on early payoff versus investing for retirement) and they actually favor investing quite a bit more than paying down the mortgage more aggressively. But having a paid for house is an intangible that you can’t really measure. This is where behavioral finance comes into play because who wouldn’t want a paid for home before the age of 45? So let’s crunch some numbers here and see what we get.

Read my dedicated blog post on this very topic: Pay Off Mortgage or Invest Even More?

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