Buying and Affording a House

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In this guide, we'll walk through the financial considerations prospective homeowners should think about when it comes to buying a house. This starts with saving for a down payment to making sure that there are enough funds for surprise closing costs that we don't usually think about, while still leaving something left over for our rainy day funds.

About 64% of Americans own the home they live in, although the majority are still paying off a mortgage. If you are thinking about buying a home, you may be facing some significant headwinds. Median new home prices have been rising rapidly in recent years, but median incomes have not. As a result, the relationship between the two is at a level not seen since 2005.

This graph shows how new home prices have been increasing relative to incomes (based on median figures) as a measure of affordability.

In 2013, the most recent year for which data is available from the U.S. Census Bureau, the median new home price was $268,900, or more than five times the median household income of $51,939 reported in that same year. (N.B. the median is different than the average household income of $63,784, which is pulled higher by the country’s wealthy outliers). Median prices of existing homes have not risen quite as much, still they are proportionally higher than they’ve been at any other time in the past 25 years (when this information started to be collected), except for the years between 2002 and 2008. In 2013, the median existing home sale would have cost the median household nearly four times their income.

How Much Money You Need to Buy a House

Many lower earning households are priced out of home-buying, and they rent instead. The median income of renter households is $32,466; while the median income of homeowners is $67,298. For those hoping to buy, one of the first questions to ask is “how much house can I afford?” Here’s what you need to consider:

Saving for a Down Payment

While there are some ways to buy a home with little money down - for example, mortgage loans through the Federal Housing Administration may require just 3.5% of the purchase price as a down payment - they tend to hurt you over the long run with extra costs.

Your best bet is savinga full 20% of the home price to use for a down payment, if that's possible. This allows you to avoid the requirement for private mortgage insurance, which costs about 1% annually on the amount you’ve borrowed until you have accumulated 20% equity in the house, in most cases.

More Savings for Closing Costs and Other Expenses

Most would-be homeowners know about the need for a down payment, but some are surprised by closing costs. This is the money that covers things like loan origination fees, an appraisal, title insurance and lawyer fees. It typically amounts to between 2% to 5% of the purchase price of the home. On the median existing home priced at $208,300 in 2014, the closing costs could range from $4,000 to $12,500. This is money that you must spend outright and will not get back. Unlike your down payment, it does not become part of the equity of your home.

Once you’ve closed on the house, don’t forget you’ll probably want to move into it, so you’ll also need a little money put aside for moving costs. New costs related to owning a home might crop up as well, such as purchasing a homeowners insurance policy.

Your Emergency Fund

You still need to keep some cash in easily-accessible savings, probably more than you had as a renter, because if anything goes wrong with your new home, you’re responsible for it. No more calling the landlord to snake the drain or replace the fridge!

It'd be wise to have enough in accessible savings to cover six months of basic living expenses in case your income dries up. If this sounds impossible after all the cash you’re planning to pour into your home purchase, shoot for keeping at least 10% of your annual income in savings, and come up with a back-up plan if you need more, like borrowing from friends or family or withdrawing past contributions from a Roth IRA if you have one (you’ll pay no tax or penalty on that money).

How Much Mortgage Payment Can You Afford?

Assuming you don’t have enough saved up to cover the entire purchase price of the home (or, even if you do, you may not want to sink it all into the house), you will need a mortgage. You’re surely wondering: how much mortgage can I afford? In determining how much they are willing to loan you, lenders will look at your income and at your debts.

As a general rule of thumb, lenders prefer if your mortgage payment, including principal, interest, property taxes and insurance, is 28% or less of your gross household income. Some lenders will allow that percentage to creep a few percentage points higher, however, economists consider a housing payment of 30% of income or higher to be a burden.

The other factor mortgage lenders strongly consider is the percentage of your monthly income that goes to other required payments, for things like student loans, car loans and credit cards, as well as things like child support or alimony. Lenders are still typically willing to work with you as long as that amount is no more than 15% of your income.

Lenders will generally approve a combined total of required housing costs plus required debt or other payments if they are 41% to 43% of your total income. In rare cases, this can stretch to 45%.

Make Home Ownership Work for You

Don’t adhere blindly to what lenders say you can afford. Look over your own budget with a critical eye. You may have some costs that they’re not seeing; like pricey childcareor expensive health insurance premiums.

The average U.S. household spends just 16% of its income on non-recoupable housing costs—either rent payments, or monthly house payments that do not lower the mortgage principal (including mortgage interest, property taxes, maintenance and insurance.) A 28% or higher mortgage payment, which tends to be front loaded with interest payments, could feel like a tight squeeze at first. The beauty of a fixed mortgage, of course, is that the payment will remain the same for the duration of the loan, or until you sell or refinance the house. As long as your income goes up over time, the mortgage payment should become more manageable.

Keep Renting or Buy a Home?

Given the hefty upfront costs, payments to the realtor on the back end when you sell, and the uncertainty of the future of housing prices, you might legitimately wonder if it’s worth it to buy a house at current prices. Even with the tax breaks. Keep in mind that you only get that benefit once your mortgage interest, along with your other deductions, exceeds your household’s standard deduction.

The critical piece of information you need to make this determination is this: what’s the alternative in your area? After all, rents have been rising sharply too.

As with many things financial, it’s an individual decision based on the specific options that are available to you. Check a rent vs. buy calculator to see how the expenditures compare.

If you choose to rent though, you must be a diligent saver in other types of accounts, because unlike homeowners, you don’t have what might amount to a forced savings plan. Homeowners build up a little more equity with every mortgage payment, so when they sell the house they will typically end up with a chunk of money to either roll into a new home purchase, or live off of as a renter once again.

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