How Much House Can You Really Afford?

Posted by Darrow Kirkpatrick  Mar 1, 2021

Google “How much house can I afford?” and you’ll be awash in a sea of mortgage lenders. This is the mindset that younger people and the average consumer must take when it comes to buying a home: How much will a financial institution loan to me? And many, sadly, make their financial decisions based on how much they can borrow. They assume that you would want the maximum allowed.

How much house can I afford image with calculator

But FIRE-oriented folk, potential early retirees, and the financially independent are likely to look at the problem from other, different perspectives. The first might be, how modest a house can I live in, and still be happy? Another perspective might be, how will this impact my budget and savings rate long-term? A final perspective, since many in that group can afford to pay cash, is not how much will my income qualify me to borrow, but rather how much of my net worth can I sink into a house without taking on undue risk or compromising my cash flow?

Is the answer to that question essentially the same as for the borrower, who is qualifying based on income? Or is it somehow different, when you are buying a home outright? When I was faced with the home buying decision late last year, I had to answer this question for myself….

Qualifying for a Mortgage

Let’s take a look at the constraints on housing deals using traditional mortgages. As we’ve said, the lens through which the vast majority of people look at home affordability is simply, how large a mortgage can they qualify for? Not surprisingly, the mortgage industry has a well-tested rule of thumb for making the determination. It’s known as the “28/36” rule.

According to FreddieMac, and many other mortgage resources, you should take on no more than 28% of your monthly gross (pre-tax) income in a mortgage payment — principal, interest, property taxes, home insurance. (Note that maintenance and utilities are not included in that number, whereas HOA dues might be.)

The relation of mortgage payment to gross income is known as the “front-end ratio”. It’s found by dividing your monthly housing expenses by your gross income and multiplying by 100. Some underwriters allow higher percentages, and some require lower. I’ve seen ratios as low as 25% and as high as 30%. But 28% is the most common rule.

For most people, “gross income” would just be wages. For a retiree, it would be the combination of pensions, Social Security benefits, and perhaps investment withdrawals, using a conservative safe withdrawal rate. Individual institutions are likely to have their own rules for getting a mortgage based on assets.

The 36% number is known as the “back-end ratio.” It’s the suggested upper limit once you add in monthly payments on all other debt to your housing expenses and divide by your gross income. This is an attempt by your creditors to keep your overall debt manageable.

The Sweet Spot?

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