I didn't find the whole "such-and-such" percentage of your income is what you can afford on a house thing to be very helpful.
First I looked at our living expenses. I sat down with an Excel spreadsheet and wrote down every single expense that I could think of. I keep pretty good records of what we spend in my financial software, so I was able to get a realistic view of what we spend on food, clothing, monthly bills, annual bills, vacations, trips, utilities, any debts. I ended up with a number that represented how much money we spend to live every month. I cross-checked this by looking at our financial software and looking at the total amount of money we spent every month, minus our rent payment. Then I added $300 to this monthly number because "stuff happens."
Next I wanted to get a realistic view of what a house would REALLY cost. Not just the mortgage/tax/PMI, but everything: the every-day maintenance, saving for long-term maintenance (furnace, roof, paint, etc), yard work, house-hobbies (like gardening), increase in electricity/gas... every expense that I could think of that I would need to take into account that did not apply when I was renting. What I find is that in addition to the mortgage we spend $350 a month on the house: $100 a month into an everyday maintenance account that we use pretty consistently, $100 into a maintenance savings account for eventual big projects like roof issues, furnace issues, flooring, house painting, etc, $100 increase for electricity, gas, and water, and $50 on gardening and yard (extra water bills, landscaping supplies, veggie garden stuff, etc.) Id this house a fixer-upper? if so, the buyer would need to add extra each month for projected expenses.
Then I looked at our monthly income. Then I subtracted our living expenses and our home ownership expenses from our income, and wound up with a number that represented the maximum amount of mortgage we could afford.
Example: This family rents and would like to purchase a home. They make a total monthly take-home income of $5400. Their monthly living expenses and debt come to about $3500, not including rent. They figure that owning a home will cost them an extra $350 a month between increased utilities, home maintenance, and homeowners association fees.
Living Expenses + Extra Home Ownership Costs = Total Costs (without mortgage)
$3,500 + $350 = $3,650.
Total Income - Total Costs (w/o mortgage) = Maximum Mortgage
$5,400 - $3,650 = $1,750 Maximum Mortgage cost
So in this scenario the buyer would want to look at a home where the mortgage cost would be less than $1750. I would aim somewhere in the $1600 or less range if this were me.
So our hypothetical family can afford to pay $1650 a month in mortgage, lets say. So what that that get us for a home price? This is quite variable because of down payment and interest rates.
Our family has $10,000 available for a down payment. They have cahs for all of the closing costs. They have pretty decent credit, and are looking for a 30 year mortgage. They have to pay .5% PMI, and tax rates are 1.25%. Current interest rates are 5%. They can afford a $265,000 home.
Or perhaps they have $10,00 for a down payment, but the interest rates have risen to 5.5% Now they can afford a $254,000 home, which is $10,00 less than they could afford with the 5% interest.
Or wow! The interest rates just plummeted to 4.5%! Same down payment, same tax/PMI rate. Now our family can afford a home for $278,000!
What worked best for us was to figure out how much we wanted to pay per month, maximum, as demonstrated above. Then we went to our credit union and ran numbers with them. We figured out what we might need for a down payment, what we were looking at for hypothetical closing costs, and how much they were willing to loan us. Then we looked at our maximum house costs based on the current interest rate and monthly payment amout, and started looking around out there at what we could find in and below our price range.
Edited by tinuviel_k - 12/22/11 at 11:25am