The Bank Does Not Set Your Budget
You and your spouse make a combined $175,000 in gross income. You have $125,000 in student loans with a 6% interest rate and a term of 10 years. ($1,385 per month)
28% rule: $175,000 x 0.28 = $49,000 per year or $4,083 per month
36% rule: $175,000 x 0.36 = $63,000 per year or $5,250 per month
Since your actual debts are already $1,385 per month the bank will subtract that from the 36% rule and then figure out which number is lower when deciding your pre-approval amount. Using the lowest number the bank determines that you can afford up to $3,865 per month in house payments.
Woohoo! The bank says you can afford a $675,000 house!
(Spoiler alert: You can’t.)
There are many ways you calculate your own home-buying budget but a good rule of thumb is the “50/30/20 rule”. The idea is that 50% of your TAKE HOME income should go to your needs, 30% to your wants, and 20% to savings. Needs are things like food, clothing, transportation, medical needs, student loans, mortgage (or rent), insurance, and property taxes. Wants include entertainment, vacations, charitable donations and any extra you want to throw at your student loans or other debt. Savings include traditional savings accounts, extra retirement contributions, and wherever your stash you emergency fund. Remember, this is take home pay, which really should be what you bring in after taxes and after maxing out your 401k match through your employer. Let’s run our numbers again with a few more details:
$175,000 in gross income – Equates to roughly $100,000 after taxes, retirement and insurance. ($8,333 take home per month).
Needs: $1,385 per month in student loans. $750 per month in food, $400 for transportation and clothing.
$8,333 x 0.5 = $4166 – ($1385 + $750 + $400) = $1,866 for monthly housing costs
Congrats! You can afford a $300,000 house!
Less than HALF than what the bank pre-approved us for.
There are many ways to calculate a housing budget. You should find a method you are comfortable with. I like the 50/30/20 calculation because it is specific enough to illustrate what you can really afford but flexible enough to allow you to adjust certain things based on your individual needs. Regardless of the method you use, calculate the number for yourself instead of allowing your lender to fool you into looking for a house you really can’t afford.