Where's My Trust Fund?

We have been casually looking for a new house since last spring.  During this time we have been having a lot of conversations about where we want to live, what kind of house we want, and what different mortgage amounts would mean in the long term as a financial commitment.  I have also been doing some research on prudent numbers to use for guidance when determining how much we can spend on a new house.  It’s taken me awhile to let the reality of the numbers sink in, particularly since the numbers I am coming up with for us are drastically different from what the bank is willing to lend us.

It’s not how much the mortgage lender said you can afford

We currently live in a two bedroom condo that was purchased during the housing boom.  When I called to determine my housing budget, and I naively assumed the bank would help me with this, I was told I could take out whatever sized mortgage I wanted or needed.  As someone who had recently finished grad school, spending the majority of my savings on the endeavor, and who had a job offer but no pay check, I was stunned.  Lesson learned- do not rely on the bank to help you determine your housing budget.

Flash forward almost 6 years.  When I spoke to our mortgage lender, he mentioned that they currently use the 28%/36% guideline in determining maximum mortgage amounts.  Your all in housing cost, including property tax and insurance should not be more than 28% of your gross income, and total debt payments, including all housing costs, should not be more than 36% of your income.  The implication of this, is that if you have a lot of current debt, you will not be able to take out as much debt.

This is actually the formula I used six years ago when determining how much home I could afford.  While things have worked out for me, if I had it to do over again I would spend less.  Using the 28%/36% rule left me feeling incredibly house poor and has motivated me to rethink things before purchasing our next home.  This level of debt, while in some regards manageable, left me with very little wiggle room in my budget and with little room for any sort of financial emergency or fun.

Using these guidelines, if you have a gross household income of $100,000, you would be able to take out approximately $370,000  in mortgage debt assuming you have no other debt and using a 5% interest rate.  This amount would vary depending on insurance and tax amounts.  Here is a calculator if you want to do your own analysis, look at the conservative number.

After doing some research, and evaluating our own situation, there are two rules of thumb I am using when thinking about our next home purchase:

1) 20% down payment in addition to other savings!

When determining our housing budget, it is tempting to looking in our savings account and assume this is what we can use as a down payment.  However, houses need to be filled, emergencies still happen, and cars still need to be replaces.  So when saving for a down payment, you need to have your 20% down payment on top of your emergency fund and any other things you may be saving for right now.

More and more, banks are requiring you to put 20% down with home purchases.  If you do not put 20% down, you will have to pay PMI insurance.

2) Maximum mortgage loan you should take out is about 2x your salary

When I first started doing research, I kept seeing 3x, or you can take out a mortgage that is three times your gross annual salary.  Since that is an amount similar to what is recommended by the 28%/36% rule I kept looking for answers.  It was my 91 year old grandmother who first mentions the two times your salary idea.  My grandmother is a child of the Great Depression and very financially conservative.  She mentioned that when she built her house 60 years ago, they paid just slightly over two times their salary, which was the standard rule of thumb back then, and things were tight for them for awhile.  I came across this number again while reading the Millionaire Next Door.

I love this ‘rule of thumb’ in its simplicity.  I hate it because it drastically decreases the amount of our housing budget.  Continuing with the example from above, while the 36%/28% rule would allow you to take out a $370,000 mortgage, the 2x rule would leave you with a $200,000 mortgage.

After figuring out that I am most comfortable with the 20% and 2x rule, I still have questions.  Namely, do we want to use one or both of our incomes when calculating the 2x?  I most definitely will only use our base salaries, leaving out bonus pay that can vary a lot from year to year. In addition, does is make sense to put down more than 20% provided other savings are still in place?

So with a drastically reduced housing budget, we are currently sitting tight and casually looking.  If we find a house we’re excited about within the 20%, 2x rule, we’ll likely make the move.  Meanwhile, we are saving more money and making do in increasingly cramped quarters.