Welcome back for Creating a Housing Budget series – Part 2!
Last week, we learned how to create a plan to help shape our housing budget and this week we will put those steps in motion.
To help summarize the key points from last week, I created a DIY housing budget guide. Outlined below are the 7 steps you can follow to get a very good approximation of what you can afford to pay. However, for those who want an easier and quicker way to do it online, you can skip the 7 steps and corresponding example by using the following affordability calculator. Either method will help you “buy what you can afford.”
7 Step Housing Budget Guide
Calculate Maximum Housing Payment
- Cap it at 28% of gross income.
- Total debt-to-income (DTI) ratio to never exceed 36%.
- If DTI is above 36%, the housing payment needs to be lower than the 28% rule of thumb number so that all debt payments are equal to or less than 36%.
Convert Housing Payment to a Lump Sum Mortgage Estimate
- Quick way to calculate – for every $100,000 borrowed at 4.5% on a 30-year mortgage, your payment will go up by approximately $500 per month.
- Your monthly payment will also adjust $30 per month for every 0.25% change in interest rate on each $100,000 borrowed over 30 years.
Estimate Property Taxes and Insurance
- Annual Property Taxes (Saint Johns County) = 1.088% of Purchase Price
- Insurance Estimate = $35/month for every $100,000 in Home Value
Convert Housing Payment to a Mortgage Estimate by Factoring in Property Taxes and Insurance
- Subtract monthly cost of property taxes and insurance from housing payment in Step 1.
- Convert the reduced monthly payment to an adjusted target price by using the $500/month for every $100,000 borrowed rule of thumb.
Calculate Down Payment and Closing Costs
- Down Payment = [Savings Account + Proceeds from Sale of Home] – [3 Months Living Expenses + Closing Costs]
- A shortcut way to estimate closing costs is to multiply 2.5% by the price of the home.
- Commission and variable incomes should keep 6 months of living expenses.
Add Back the Down Payment to the Mortgage Amount to Arrive at an Estimated Target Price
- Target Price = Mortgage Estimate + Down Payment
- Almost there…other costs like PMI, HOA, and CDD fees are not yet included
Research Properties to Fill the Cost Gaps and Adjust Housing Budget Accordingly
- Search for properties through your realtor or sites like ZIllow to gather actual data
- Make adjustments to your budget based on the other costs not yet captured, such as PMI, association fees, and community development dues.
- PMI = [0.75% x Borrowed Amount] / 12
- Association and community development dues vary by neighborhood.
Now that you have a 7 step process, how do you actually implement all of these budgeting tips? The best way for all of this to stick is to learn from a real life example and show you how to run the calculus.
Real Life Example
Example: John and Suzie Jones are married with 2 kids and are looking for homes in the Ponte Vedra area. They are first-time homebuyers. The Jones’ have $75,000 in savings and make a $130,000 combined salary. Unfortunately, in her younger years Suzie switched majors at a private out-of-state college and was on the 6 year plan, therefore she has a sizable student loan payment of $1,200. Total monthly expenses, including all debts and rent, currently run them at approximately $7,000. Interest rates on 30-year mortgages are 4.5%. Given their lack of experience, the Jones’ are not sure what they can afford and need help figuring out their budget.
Step 1 – Take 28% of gross income to calculate the maximum payment, and make sure all debt payments are less than 36% of gross income.
- Housing Payment @ 28% = ($130,000 x 28%) / 12 = $3,033
- Debt-to-Income (DTI) @ 36% = ($130,000 x 36%) / 12 = $3,900
- Projected Debt Payments = $3,033 Housing + $1,200 Student Loan = $4,233
- Projected DTI = $4,233 / ($130,000 / 12) = 39% → over the recommended level of 36%
- Reduce Monthly Housing Payment = $3,900 Debt Limit – $1,200 Student Loan = $2,700
- Recommended Monthly Housing Payment = $2,700
Step 2 – Convert the maximum monthly payment into an initial estimated purchase price using the “$500/month for every $100,000 borrowed” rule of thumb.
- $2,700 / $500 = 5.4 (multiplier) → 5.4 x $100,000 = $540,000 max target price
- Property taxes and insurance have yet to be included so the target purchase price will get reduced even further.
Step 3 – Calculate property taxes and insurance.
- Property taxes = 1.088% x $540,000 = $5,875.20 → Monthly = $490
- Insurance = $35 x 5.4 = $189
- Total Taxes and Insurance Payment = $679
Step 4 – Reduce the maximum payment by taxes and insurance, then convert the payments to a lump sum mortgage estimate.
- Mortgage Payment Estimate = Max Housing Payment – [Property Taxes + Insurance]
- Mortgage Payment Estimate = $2,700 – $679 = $2,021
- Mortgage Affordability Conversion = Mortgage Payment Est / $500 = multiplier x $100,00
- Mortgage Affordability Conversion = $2,021 / $500 = 4.04 → 4.04 x $100,000 = $404,000
Step 5 – Estimate the down payment and closing costs.
- Initial Down Payment Estimate = $75,000 savings – (3 x $7,000) = $54,000
- Closing Costs = 2.5% x $404,000 = $10,100
- Proceeds Available for Down Payment = $54,000 – $10,100 = $43,900
- This is a little over 10% of the purchase price, which means there will be PMI
Step 6 – Add back the down payment to the borrowed amount to arrive at an estimated target price.
- Borrowing Target = $404,000
- Down Payment = $44,000 (rounded up)
- Target Price = $404,000 + $44,000 = $448,000
Step 7 – Research properties and account for other costs like PMI, association fees, and community development dues – adjust housing budget accordingly.
- PMI = [0.50% x $404,000] / 12 = $168 per month
- Check listings for HOA and CDD fees → $150 per month
- Total other fees = $318 per month
- Adjustments to housing budget at a 4.5% interest rate for 30 years
- Mortgage payment target = $2,021 – $318 = $1,703
- Mortgage amount target = $1,703 / $500 = 3.41 x $100,000 = $341,000
- Purchase price target = $341,000 + $44,000 (down pmt) = $385,000
For a lot of readers, crunching the numbers is enough to make your head spin. Which is okay. Developing a well-thought out housing budget doesn’t come naturally. It is why I recommend leveraging the expertise of a realtor and a financial planner, so that you have a team of professionals to help you get it right. Both experts can help you keep more money in your pocket. A great realtor will ensure you negotiate a fair purchase price and don’t overpay for something. Then, once you find “the house,” have a financial planner confirm your decision by reviewing the long-term financial impact.
Life is a lot easier when you understand the financial responsibility that comes with homeownership.
If anything else, the biggest take away to remember when shopping for a house is to, “only pay what you can afford.” Buying a home is one of the biggest purchases you will ever make. Therefore, it is in your best interests to have a very targeted price and remain disciplined during the shopping phase. Doing so can make all the difference in landing your dream home actually becoming a reality.
About Scott Snider and his company’s services….
Scott is the founder of Mellen Money Management, a fee-only, independent financial planning firm locally based in Jacksonville, Florida. In a nutshell, Scott helps clients plan for the financial impact of major life events, so that they are prepared for life’s biggest moments. Such an approach has helped his clients live a more fulfilling life. Mellen Money Management’s financial services include investment management and comprehensive financial planning. While their specialty is all things college — they help families pay less for college and young professionals tackle their student loans. It is their mission to end the student debt crisis one client at a time. To do so they believe the cost of college cannot be solved in a vacuum and that financial trade-offs, like saving for retirement, must be prioritized in a way that one goal doesn’t come at the expense of the other.