May 4th, 2011 2:27 PM by Arturo Torres
If the last few years have taught us anything, it's this: Never buy more house than you can afford.
The amount you can really afford might be less than you have been led to believe, particularly by people who stand to make more money the more they can talk you into spending.
That's nothing against salespeople -- they're only doing their job. But you wouldn't ask a car salesman how much you should spend on a car (We hope!).
Before the first round of house hunting, make sure you decide -- with no outside pressure from real estate salespeople or anyone else -- the maximum amount you will spend on a house.
Too many people spend every dime and take out the biggest loan they can get to buy a house, and in no time start losing sleep wondering if they can make their mortgage payments.
Follow these 4 simple rules, however, and you'll have little or no trouble paying for your home.
Rule 1. Spend 30% or less of your gross (pretax) income on housing costs.
Add together monthly income before taxes and other deductions from your job, your spouse's job, and part-time or side businesses if applicable.
Multiply that number by 30%. The result is the maximum total amount you should spend on monthly housing costs -- including principal and interest on the mortgage, property taxes, condo or association fees and insurance.
For years, the U.S. government has defined an affordable home as one that costs less than 30% of your pretax monthly income. Spending less is even better.
Liz Weston, author of The 10 Commandments of Money, recommends keeping your housing costs down to 25% or less of your income.
For example, if you make $60,000 a year and have no debts, you can afford to spend about $1,500 a month on principal, interest, taxes and insurance without breaking the 30% rule. To keep housing costs down to 25% of your income, as Weston recommends, you'll have to spend $1,250 or less.
Nearly 37% of homeowners with a mortgage -- 19 million people -- now spend more than 30% of their income on housing.
That's one crowd you don't want to follow.
Rule 2. Spend no more than 36% of your income on total monthly debt payments.
The more nonmortgage debt you have, the less you can afford to spend on a home.
Multiply your income from Rule 1 by 36%.
Plan to spend no more than that result on your total debt payments -- mortgage payments, auto loans, student loans, credit card bills, child support and loans against your 401(k) plan.
For example, if you make $60,000 per year but you spend $300 a month on car payments, $125 on credit card bills and $200 on student loans, the 36% rule would limit your monthly housing costs to $1,175.
It's easy to put those rules to work. Just enter your income and nonmortgage debt payments into our mortgage calculator, and we'll tell you how big of a loan and monthly payment you can afford.
Rule 3. Don't loot your retirement accounts for a down payment.
The substantial down payments lenders are demanding could limit how much you can afford to borrow.
With so much savings tied up in retirement accounts, an IRA or 401(k) plan may seem like the only place to turn for that kind of cash.
Think twice before taking money out of retirement account for a down payment, however. Retirement accounts are secure, safe from creditors. Equity in your house is not. If you take cash out now, you'll lose the protected status of retirement accounts and jeopardize your retirement income.
In addition, you can't take money out of most retirement accounts without paying a penalty and taxes. By the time you do that, you won't have as much money left as you thought. For example, if you take $20,000 out of your IRA and paid a 10% penalty, plus 30% in federal and state income tax, you'll only have $12,000 left.
You can borrow from a 401(k) or similar plan (but not an IRA) if your plan allows it, but that's risky. If you lose or quit your job, you have to pay it back. Besides, retirement savings are for retirement.
If you must tap a retirement account, and one of your accounts is a Roth IRA or Roth 401(k) plan, tapping it may make sense. Unlike other kinds of retirement plans, Roth plans contain contributions that have been fully taxed. That means you can make withdrawals up to the amount you have contributed without paying additional taxes or penalties. (See your accountant for specific rules before you move any funds.)
Rule 4. Move in with a reasonable rainy day fund.
When anything goes wrong for people who live paycheck to paycheck, they have nowhere to turn.
A job loss, emergency home repair, disaster, or health problem could easily keep you from being able to pay your mortgage. Record numbers of homeowners have lost their homes under such circumstances.
You can increase your financial security by keeping three- to six-months' income in an easily accessible savings account or other emergency fund.
You should also have enough cash on hand to cover home repairs, expected and unexpected. If you have to call a plumber on the weekend, for example, count on spending at least $200. Weston recommends allocating 1 - 3% of the cost of your home to annual repairs and maintenance.
You need a larger emergency fund if you have a high deductible on your homeowners insurance, and – if you have it, high-risk insurance for such disasters as floods and hurricanes.
According to Consumer Reports, there's a growing trend for your deductible to be a percentage of the insured value of your home.
"In many states, homeowners now have two deductibles: one for their main policy and another for a high-risk peril such as a windstorm or a hurricane. Florida requires a hurricane deductible of 2% for homes valued at $100,000 or more."
Insurance plans with higher deductibles are good because you save on premiums. You must be prepared, however, to pay the deductible out of pocket when disaster strikes.