How much house can you buy?
This is a guest post from Pauline of InvestmentZen.com. Pauline left the 9-5 seven years ago to live life on her own terms, and is currently based in sunny Guatemala.
When I went to the bank to apply for a mortgage for my first property, I was given a straight no. The reason was, I was only going to be employed for the next couple of months, and even if the rent would cover the mortgage, the bank wanted more guarantees.
Even then, what the bank tells you you can borrow isn’t necessarily what you should be borrowing. In this case, the bank only took into account my salary. They required that no more than 35% of my income go into the mortgage.
But if you go from renting to buying you first property, there is more to it. For example, if you currently live a 10 minutes drive away from work where you rent, but are priced out of your neighborhood when it comes to home ownership, the added mileage you’re going to have going to work every day should be included in your extra expenses. The same applies to the property tax, the HOA fees, the extra hour of day care you might need every day, and so on.
Actually, sometimes it makes sense to buy a more expensive property closer to work. The town I lived in Surrey was 35 minutes away from London by train. Properties were not that much cheaper because the surroundings were lovely and a lot of traders from the City wanted to live there so their kids would grow up with a garden and great public schools. A 12 month train pass costs a whopping £3,600. Add to it the hour you’re losing every day in the train, and you might be better off buying more house closer to the city, or having more cash to pay off your mortgage early.
Anyway, there are a lot of rules of thumb to calculate how much house you could afford.
The “should you buy or rent” calculation
If your yearly rent is less than 15 times the cost of the property, it makes sense to buy. So if you are paying £1,000 a month on a £120,000 property, that is £12,000 a year, the ratio is 10 and it makes sense to buy.
If your yearly rent is 15-20 times the cost of the property, it is generally better to rent, and if you are over 20x, it is much better to rent. If you are paying £500 on the same property, your ratio is 20, you should keep renting. Some areas where properties are crazy expensive (San Francisco, NYC..) make a strong case for renting. You can however look for rental properties elsewhere, while you rent for yourself in a more expensive area.
Housing costs should be less than 40% of your net income
You don’t want to spread yourself too thin with your first buy, and your housing costs, including taxes and a maintenance fund (which is generally calculated at 1% of the purchase cost), should not exceed 40% of your take home pay. So if you make £2,500, you shouldn’t pay more than £1,000 for your mortgage plus additional expenses.
You shouldn’t buy a house that costs more than 4x your gross income
I found that one to be pretty strict in the UK, with some lenders going as low as 3x your gross income. I was annoyed because they wouldn’t take into account my 99% guaranteed bonus, since it was not 100% guaranteed, or any freelance income.
But a good rule is if you make £50,000 a year, you shouldn’t buy a house that costs more than £200,000.
Your fixed costs should be 50% of your take home pay
This rule includes all of your recurring expenses. We are talking housing costs, but also car loans, student loans, miscellaneous debt repayments, cell phone bills, utilities and so on. If you make £2,500, the previous 40% rule allowed you to spend £1,000 on your mortgage, but it seems unlikely all these additional expenses would sum up only £250. I think this is a much safer rule, since it includes all of your monthly commitments, and allows you to keep 50% of your take home pay to afford groceries, clothes, hygiene, holidays and other stuff.
If you passed all these ratios, you are probably good to proceed on your home purchase. But one last thing to remember are market fluctuations. Your house could lose value over the next 5-10 years. Over 30 years it is unlikely you will lose money with real estate, especially considering you didn’t get to pay rent for three decades. Nevertheless, if you are young and thinking about buying a first property, you should make sure you won’t need to sell it anytime soon, and risk losing money.