As you may have noticed, the airwaves are filled with bleak, sad stories of foreclosures and bankruptcies. It may seem hard to believe, but the national home price is off nearly 25 percent from its peak — and that's just the average. Certain states in the U.S. (California, Nevada, Florida, and areas in the Midwest) have seen even more dramatic declines, according to the widely quoted Case-Shiller index of home prices. The headline is this: Millions of Americans are literally being held hostage by their homes. And, inquiring minds want to know…
…How Much House Can I Afford?
The rule of thumb is that a military family can comfortably afford a home that is up to three times their average annual household income. Where did this number come from? Well, think of your annual income as a pie. It has four slices: taxes, savings, needs, and wants. For most people, taxes chew up about 25 percent of their gross income. In an ideal world you should save 15 percent of your gross income. So that leaves you with 60 percent of your gross (or pre-tax) income for everything else. Your housing costs, your transportation costs, your health care, your child care, your food, your entertainment, etc.
If you buy a house with a 20 percent down payment and a 30-year fixed rate mortgage —average interest rates dictate that you’ll spend about 30 percent on your mortgage, insurance, property tax, maintenance and upkeep — that leaves you with 30 percent for everything else in your life. If you buy a house that’s three times your annual income, those housing costs will take a big bite out of your budget, which sets the financial into motion. You’ll either have to cut back on your wants or cut back on your savings.
As you think about home ownership, here are three rules of thumb that can help:
- Only buy a house when you can afford to make a 20 percent down payment.
- Only use a 15-year, or 30-year fixed rate mortgage.
- Only buy a house if you think you’ll live there for at least five years (because otherwise the costs associated with buying and selling your home have high odds of exceeding any gains you may make from price appreciation).
The aforementioned thoughts are meant to serve as a broad, general framework, not a one-size-fits-all answer. The key point to take away from this discussion is that for a free-market economy to function efficiently, we must have informed participants.
In the past, lenders did not disclose enough about their terms, and buyers did not ask enough questions. There are many parties to blame and it will take all hands on deck to right this ship. All of us can do our part by taking personal responsibility for learning how much home is right for our personal circumstances. You want your home to be your haven, not hold you hostage.