NerdWallet's Smart Money Podcast - How much house can I afford?

Episode Date: October 21, 2019

Think you’re finally ready to buy a home? Here’s how to know how much house you can afford with your budget, what you might need for a down payment, and how to think about the emotional aspect of homebuying.

Hello, and welcome to NerdWallet's Smart Money Podcast, where we answer your real-world money questions in 15 minutes or less. I'm your host, Sean Piles. This week, I'm joined by a total nerd for home buying, Holden Lewis. Holden has been writing about mortgages for 18 years. He's also won a bunch of journalism awards, and he used to be the president of the National Association of Real Estate Editors. 18 years. If my first mortgage article had been a child, it'd be a freshman in college now. I don't even want to think about that. So Sean, what's this week's question?

I mean, I think that you should actually cherish the amount of experience that you have. It means that you should hopefully know what you're talking about here, as I believe you do. And I'm happy to have you on the show. So our question this week comes from Steve in Denver. He asks, I'm looking to buy a house in the next year, but I'm not sure what I can afford. How can I know how much house I can afford? Well, Steve, that sounds like a simple question, right? But the answer, it's not simple.

This is a question about money, and there are a lot of feelings around money. So there's the number part of the answer and then there's the emotional part of the answer. Especially with home buying, we have these ideas about the ideal life we want and how buying the perfect house will help us achieve that, the whole American dream, picket fence type thing. But if the money math doesn't add up, you can end up house poor and unable to really enjoy this life that you've sunk a bunch of money into, and unable to even afford things like repairing that picket fence when something happens to it. In this episode of NerdWallet's Smart Money Podcast, we're going to break down how much

house you can afford with your budget and savings, including why you may not need that 20% down payment anymore. And at the end, we'll give you the takeaway tips to help you jumpstart the home buying process. All right, let's get to it. Okay, so Holden, let's get to know each other a little bit here. How have you handled your money in the home buying process in the past? I have a modest house. And I have a 19 year old minivan and a 20 year old car and that frees up money so we could pay our son's expensive college tuition and we dine out a lot, we buy books, you just wouldn't believe how big our bookcase is and we spend too much on travel. Okay, so it seems like you've shuffled around your priorities. So you're spending less on a house. So you can spend more on things that you do care about, like going out to eat, traveling,

buying more books than you can read in a lifetime, and not having a fancy car, not having a fancy house makes it so you can fund those things. That's exactly right. One thing I'm kind of wondering about here is, you know, there's this old adage that you need 20% down for a down payment, and you maybe have to sell your firstborn here. How did that play out for you with your first time buying a house? The reason we bought a house is that we had a little boy. He was less than a year old, and we were living in an apartment. And I had this vision of him taking his first

steps in the living room of a house we owned. Well, that didn't give us time to save up for a down payment. We had to buy with whatever we had, which was a lot less than a 20% down payment. So I actually feel like a lot of our listeners are going to have the same experience here where they want that home to meet that lifestyle goal of theirs, but their numbers maybe aren't totally where they should be for that. So let's just dive into the numbers to start. When someone is figuring out how much house they can afford, what is the very first step? The first thing to do is use a home affordability calculator. We have one at NerdWallet where you tell it the following things, where you want to live, how much you make, how much of a down payment you'll have, how much your monthly debt payments are, and your credit score level. Then it tells you

approximately what the maximum house price is that you can afford and the approximate monthly payment. Okay, got it. So one thing that I think people should keep in mind is that even though this calculator will show you the maximum amount that you can afford, it's likely not a good idea to buy that maximum house. Because if all of your money is going toward that, you may not be able to do things like repair a broken pipe or go out to eat. So when you use this calculator and look at the monthly estimated payment, make sure that it fits into your overall spending plan. And you can still cover things like retirement savings, student loans, auto loans, all of that stuff. Right. I mean, you live in Portland, Oregon, man. You've got fine dining. You've got local wines, which we don't have in South Florida where I am, right? So when we talk about mortgage affordability, there's this regulation called the Qualified

Mortgage Rule. And it says that your mortgage and your other debt payments shouldn't be more than 43% of your pre-tax income. Let's say you make $5,000 a month. That's about the national median. And the qualified mortgage rule says that all of your debt payments, your mortgage, student loan, auto loan, all of those things, they should not total more than 43% of that or $2,150 if you're making $5,000 a month. And even that would be pushing it. Okay. And so that's a lot of numbers here. If your head is spinning from all of that, like mine, Holden, what do you think is a simpler way to figure this out? And is there a way that has a little bit less risk? Because 43% of pre-tax income seems still like a big chunk of your budget. It is, especially because, of course, you're paying taxes on top of that 43%. So it doesn't

leave you a whole lot of money to do other stuff. So there is another guideline, and this one is one that banks used for a long time until things went crazy before the housing boom in the early 2000s. You know, the one that went bust in 2008. This other guideline is, it's like that 43% rule that I was just talking about, but this one limits debts to 36% of your pre-tax income. And that's the rule of thumb that NerdWallet's Home Affordability Calculator uses. So it means that if you earn $5,000 a month, your total debt payments shouldn't

be more than 36% of that, which is $1,800 a month. So that's more conservative and it encourages you to buy more within your means. And, you know, it gives you room to save for retirement and college and going out. Okay. Yeah. That seems a little bit more affordable overall. One thing I want to dive into here is kind of the elephant in the room with the home affordability conversation is down payments. And you know, in the past, it was expected that you would fork out 20% of the housing costs for the down payment. And where I live in Portland, Oregon, the median home price right now is a little over 400k. So 20% of that would be around 80k. And the prospect of saving that amount seems

incredibly daunting, if not impossible. What do you think is the reality here? And what are the options for folks who can't really afford that? Most first time buyers, they make down payments far less than 20%. They're putting three or three and a half percent down, maybe five percent. They have to pay that mortgage insurance or PMI, yeah, but you know what? Paying mortgage insurance is fine. Don't let anyone tell you it's a waste of money and that you should put off buying a house until you have 20% save for a down payment, especially if that's years down the road. During those years of saving, house prices are going to keep on rising. You'll be renting when you'd rather be owning. The way I look at it is you have one life. If you want to

buy a home and you can afford to, go for it. Okay. And I want to dig into that mortgage insurance question a little bit more. I'm wondering if you can break out some pros and cons for listeners here of mortgage insurance. Certainly. you know, on the pro side, PMI lets you buy that home now instead of waiting years to save up 20% down payment. And you start without much equity, but you begin building equity with your first house payment. The main con is the cost. Yes, it is adding to your monthly mortgage payments, and it's not tax deductible. And it's also another example of how it is expensive to be poor, but we can talk about that another time. One thing I want to kind of dig into here, do you have an estimate for how much folks can expect to pay with their mortgage insurance monthly?

Oh, sure. It can vary from like half a percent to a little bit more than two percent a month. And it depends upon the cost of the home and the size of your down payment and your credit score. At NerdWallet, we have a PMI calculator that will give you a ballpark estimate. That's a good place to start. Okay. One thing that's kind of interesting with the mortgage insurance is that it seems like it's the bridge between the numbers game of affording a home and the emotional aspect of wanting a home. If you don't quite have the savings for a down payment, mortgage insurance can get you there if that's what you really want to do. And I want to dive into that emotional aspect. But before that, let's do a quick recap. So we've run through the math of how you can tell how much house you can afford and pointed you to a few calculators on NerdWallet

that can do the heavy lifting here for you. And we've talked about the options for making a down payment. Holden, let's dive into the emotional aspect of wanting a home. How do you think about this? The way I look at it is owning a home is kind of like having a child. It's a lot of responsibility. It's expensive. It's kind of scary. And sometimes it's really not the most rational thing, but it's expensive it's kind of scary and sometimes it's really not the most rational thing but it's something that we want anyway and we have that desire to own a home even though it's expensive and even though you have to fix that leaky toilet yourself or pay a plumber instead of calling the landlord in other words buying your first home is scary even as you desperately want to own your own home. Right. And it's so rewarding, which is what makes it worth it, at least for me.

Say you want to tear up that old carpet and refinish the hardwood floors. You can go ahead and do that. But as you said, you've also got to stay on top of all the maintenance there. And one thing that I find kind of interesting with this whole emotional aspect conversation is that while we have many tools that can show folks if they can manage the numbers of buying a home, there's not really a calculator that can show if people are emotionally prepared for that. So in lieu of some sort of theoretical emotional capability calculator, do you have any rules of thumb that people can use to decide whether they might be better off buying or renting? For example, I've heard that if you aren't planning on staying in a home for five years, renting might be a better option for you. That's right. So let's tackle that. There are

expenses to buying a home and to getting a mortgage. We're talking about fees that you have to pay. And so it really doesn't make financial sense to own a home if you're going to own it for less than three to five years. You kind of want to recoup those costs. What about the more emotional stuff? First, think about why you want to own a home. It helps if you can put it into words, so maybe write it down. Is your explanation full of desire and passion? Like when I was talking about having a vision of my son taking his first steps in our very own living room. I mean, that actually happened and it really made me happy. So how would you feel about the time and money you spend on maintenance? For me, it was really worth it because I got those first steps. You know, there are no wrong answers. I mean,

if you want to buy a home because you want to get a dog and you want it to have a backyard for the dog to play in, perfectly fine. Right, which is why I bought a house, I'll admit. Exactly. I mean, that is one of the main drivers for millennials buying their first homes, is having a home so they can have a dog. And so if that's your reason, more power to you, you're not alone. Let's say you want to give your kids a place to grow up. You can envision them crying 30 years from now because they're listening to that oldie Miranda Lambert sing, The House That Built Me. There's really no wrong answer. Actually, there is one wrong answer. If you're thinking of buying a home because it's expected of you, but you don't

particularly want to, I say keep renting. And if you're buying with a spouse or partner, I recommend talking about these issues, getting them all on the table so you understand each other's motivations and each other's fears. All right, so now we know the numbers and the mindset that will help people determine if they can afford a house. And Steve, I hope this helps you determine what you can afford and if you're ready for it. Let's get to our takeaway tips. All right. First, run the numbers and know how much house you can afford. Aim to keep the debt payments, including your mortgage,

under 43% of your pre-tax income and ideally under 36%. Okay. And for down payments here, note the old rule of putting down 20% need not apply. You can put much less down, even around 3%, though you will have to pay mortgage insurance as a trade-off. And lastly, even if you have the money saved up, make sure you're emotionally prepared for homeowning. It's a big commitment and it can be super rewarding, but you have to put in a lot of work too. Okay. That is all we have for this episode. Do you have a money question of your own? Turn to the nerds and call us or text us your question at 901-730-6373. That's 901-730-NERD. You can also email us at podcast at nerdwallet.com

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