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How Much Home Can You Reasonably Afford?
Whether you own your own home or rent from a moody landlord, using too much of your household income on your housing needs is imprudent practice. When you do that, your personal lifestyle can be greatly affected. A general rule as popular as the Pareto 80/20 rule is that you shouldn’t spend more than 40% of your gross household income on housing. Even at 40%, you are pushing it. Banks usually conduct stress test on less than 40% debt to ratio. But for an estimation, 40% is a good start.
Affordability Income Table
The table above shows what 40% of your income will make up. So if your annual income is $50,000 you can reasonably be able to put aside $1,667 as mortgage payments without making major changes to your lifestyle. Going above that is not recommended. Remember that these are just guidelines and not rules. You could be in extraordinary circumstances that could allow you to spend more each month.
The table also does not take into account your other financial liabilities that you have to repay each month. Other financial commitments include car loans, personal loans, education loans, etc. If you have a personal loan that requires you to repay $500 each month, it will be prudent to deduct an extra $500 from the amount you can afford monthly.
If you are taking on commission based jobs or self employed, your income can be variable or insecure. Therefore, you have to be more cautious in your approach to housing expenses. When you can confidently predict that you can get a promotion soon or obtain a big increment, you can reasonably afford a housing expense higher than the current 40%.
How much can you borrow?
Now that you know how much you can reasonably set aside from your income for repaying your mortgage, you can use this information to estimate how much you can borrow. Using a loan tenor of 30 years, the below table is generated.
Monthly payments on 30 year mortgage
As you can see. If we take the example of a $50,000 annual salary, housing expense will be set at $1,667. And if prevailing mortgage rates are at 1%, a borrower will be able to loan $500,000 worth of loan to purchase the property. However, it is important to note that just 1 percentage point increase in mortgage rates will deem a $500,000 home loan unaffordable to the borrower. Reminder that this is just a general estimate and also does not take into account loan to value.
Assuming you are able to get a loan of 80% loan to value or up to $500,000, whichever is lower, this means that you will be able to afford a property priced at $625,000.
The current low interest rate environment has made owning a dream home affordable to a lot of people. The danger lies when you leverage to the highest possible limit, and interest rates spike in future. This will cause a lot of home owners to struggle just from keeping up with mortgage payments. In theory, when interest rates spike, less people will buy properties, your property value drops, and you might have to sell at a loss to repay the mortgage or face foreclosure.
It is with this information where elders might say that to is better to buy a home where you can comfortably afford rather than a dream home that you cannot afford.