How much rent or house payment can you afford?
How Much Rent or House Payment Can You Afford?
This is a question I get frequently from clients, and there’s unfortunately no “one-size fits all” answer to this question. However, whether you’re considering rent or a mortgage payment, there are some key financial metrics and guidelines that can help you make this decision.
Conventional Rules of Thumb for Monthly Housing Costs
Most conventional recommendations advise limiting your total monthly cost of housing to 28% of your gross (before-tax) monthly income. So, for example, if your gross pay is $7000 per month, you’d be wise to shoot for a maximum housing allowance of about $1,960 per month for a rent or mortgage payment. And while this is a good rule of thumb to consider, there are other factors that may be at play in your personal financial situation that you want to take under advisement as well.
When considering the 28% recommendation for housing – look at how it factors into your other key financial ratios:
50/30/20 Ratio (For Renters and Home Buyers)
The 50/30/20 Ratio states that, as a general rule, 50% of your take-home income should be spent on non-negotiable needs (Rent or mortgage, utilities, groceries, insurance, and minimum debt payments), 30% on wants (Shopping, eating out, happy hour, concerts or sporting events), and 20% should go to savings, or to making additional debt payments if you are trying to get out of credit card or other non-secured debt. So, in the example above, if your $7000 monthly gross income results in $5,600 in monthly take-home pay, you would be wise to not exceed $2,800 per month in spending for necessities. And if the $1,960 per month that you’re spending on rent or a mortgage pushes you over that limit, you may want to reconsider whether it’s financially feasible for you to take on that payment or whether you need to look for a lower-cost housing option.
Overall Debt to Income Ratio (For Home Buyers)
Your total Debt to Income Ratio basically demonstrates to lenders what percentage of your total monthly income is going to pay off existing debts and is an important factor to consider if you are thinking of purchasing a home. Typically, a good or ideal debt to income ratio will have no more than 35% of your gross monthly income being spent on repaying debt (including the mortgage payment you’re intending to take on). So continuing with our example, if you were making a gross income of $7000 per month, ideally no more than $2,450 of that would be spent on paying down debt. That means that in order to afford your $1,960 per month mortgage payment, you’d need to have less that $490 in other monthly debt payments.
Don’t Neglect the Cost of Your Escrow Payment, Increased Utilities and HOA Fees
For first-time home purchasers, a major source of monthly-payment shock can come in the form of what you pay monthly to cover your escrow account payments. This amount essentially goes into an account that your property taxes and homeowner’s insurance are paid from. Because property taxes vary so widely, it’s hard to give an exact prediction of what this amount will be, but you can anticipate that it will typically be at least several hundred dollars, if not more in higher priced housing areas. When working with a lender on pre-approval, make sure they provide you with total monthly costs including escrow for different purchase amounts, and make sure to take that into consideration when evaluating the total cost of housing as part of your 50/30/20 Ratio. Utility costs often increase for homeowners as well because certain utility payments are factored into the cost of rent that will have to be paid separately when you own a home. And for condo purchasers, it’s also important to factor in the cost of monthly HOA dues.
Can You Cut Back Other Expenses to Commit to a Bigger House or Rent Payment?
If you were my client, I would advise against this as a plan without testing it first. If you were insistent and committed to it, I’d ask you to prove it to me. Prove to me that you can sustainably cut expenses elsewhere before you commit to a 30-year monthly payment on a home that exceeds recommended ratios. And the catch is, you can’t take it out of the 20% savings category. If you’re confident that you can reduce your “wants” spending to say, 15% so that you can afford more in the needs category, spend a year doing that before you commit to doing it for 30 years. And take that opportunity to save that extra 15%. After all, you’re about to embark on a purchase that will inevitably require a bigger buffer savings account than you needed when you were renting, so you might as well start now.
But if you’re already having a hard time meeting your 20% savings goal with your current monthly expenses or have already accumulated some credit card debt because you overspend monthly or when things come up, you are fooling yourself if you think that suddenly buying a home that increases both your monthly expenses AND your potential unexpected expenses for large-ticket items is going to fix this. It will not, no matter how alluring the idea of home-ownership is.
What If You Live in a Place with a Very High Cost of Living
This is very much a reality for many folks, and I’m not naïve to how variable housing costs are in different areas of the country. That being said, I think it’s important to have the conversation about the tradeoffs that come with being a lower-income earner in very high cost of living areas. Long-term, it is likely not going to be a sustainable way to live unless you are 1) actively pursuing a way to make more money, or 2) willing to explore alternative options for housing, like living with or renting to roommates, or possibly renting or purchasing a very small space. All of these are viable options, but otherwise, it just doesn’t compute. It’s not ever going to get easier to make ends meet living in an area where you can’t afford the cost of living unless you have a plan to either make more money or find creative ways to spend less. High cost of living areas are often filled with opportunities to make higher salaries, but if you are not pursuing those opportunities and are not willing to reconsider where you live, you may need to reconsider how you live and who you live with in order to make the available housing options affordable to you.
At the end of the day, there really is no one right way to do this. No exact rule that can answer this question for you. But ultimately, I’ve seen far too many people try and make high-cost housing options work that end in nothing but financial heartbreak and frustration. Keeping your housing choices within the realm of what you can afford is extremely important for your long-term financial health, and it also factors into preserving the life you want to live today (after all, for most people it’s a big tradeoff to let go of all their “wants” spending simply to buy the house they want… especially when considering how long the commitment to a mortgage is). But above all, I encourage you to avoid the trap of thinking you can make something work if you haven’t taken the time to prove to yourself that you can sustainably live on what’s left over after you’ve taken on the bigger mortgage or rent payment. That’s something to test before you make a life-changing financial decision, not after.
