Deciding how much you can afford to spend on your dream home can be a challenge. For most of us, buying a home is the largest investment we make, and typically we borrow to pay for it, by taking on a mortgage. If the amount you spend on the home is too high, you may end up struggling to make the payments, and the financial strain could lead you to sell the home, potentially at a loss. There is also such a thing as underspending on the home. You may find yourself desiring upgrades down the road that are hard to make on the home you purchased. While the latter scenario is probably less worrisome than the former, having to sell your home and move elsewhere is quite costly.  So how do you size the home just right?

Start by figuring out what is really important to you

A lot of people start with a percentage of their gross income to determine the size of their monthly payments. That’s a big shortcut, and one which is unlikely to lead to an ideal choice. Start instead by making a list of all the things you care about in a house. The first is location, but not in a traditional real-estate-agent sense. What’s important in your daily life? Commuting distance, schools, proximity to friends and family, dining and entertainment, etc. Don’t just think about driving to work. If you drive two or three times a day to take your kids to different places, you probably want to be close to those places. Next, think about the size and features of the home you would like. Make a list of all the things you think are important. When you do this, think ahead to your next 5-10 years. Don’t worry about costs for now. Just try to be realistic, and prioritize the items on the list.

After you have worked on this, you can narrow down your search by location and get a sense of the range of prices for the houses that fit your needs.

Make a budget

Once you have a sense of what you would like, the next step is to make a budget. If you have never done one, it is definitely worth it when buying a house. Start with a simple budget, and then refine it. The first reason for a budget is to understand how much free cash you can have at the end of each month to make a mortgage payment. The second reason is to create awareness of where your money is going. After you spend on basic necessities, are you spending on things that really matter to you? You can probably reduce spending on certain items to increase spending on some of the features of your future home. 

For example, you can probably lower your car expenses if you buy a new car less often and if you settle for a less expensive model. It’s all a matter of priorities. The best way to increase the potential of your budget is to align your spending to what you really care about. That’s what budgeting helps you do.

As you make a budget, break your expenses into necessary and discretionary. Discretionary expenses include both expenses on items that you could do without, but also spending on a good or service more than you may need (like a premium membership when a basic would do). Discretionary spending is where you can look for savings, while your necessary spending may change after you buy your house. As you work through your budget, think about how any spending item may change after you purchase your home.

Check your financial ratios

If you have done your budget and you know the house you want and you feel comfortable that you can afford it, you probably don’t need to worry about financial ratios. But in general, it’s good to see how your projections stack up against some general rules of thumbs. Your lender may look at some of these ratios too. The first to consider is the housing cost ratio, the ratio between your monthly housing costs and your gross income. Your housing costs include your monthly mortgage payments (principal and interest), property taxes, insurance, HOA fees. A rule-of-thumb is that these costs should be no more than 28% of your gross income. 

Another ratio to consider is your total debt-to-income ratio. Total monthly payments on housing and all debt, including the above costs plus your credit card, car loans, and student loans, should be no more than 36% of your gross income.  The 28% and 36% thresholds are common mortgage lender standards and seem to work on average across clients. Of course, it is possible that you could be above or below this ratio in any given month, but you should try to be below these thresholds over time. 

How close you can be to the thresholds depends on individual circumstances. Most people save for other goals, including retirement or the education of their children. For example, a common rule of thumb says you should save 10-15% of your gross income for retirement. If you have a debt-to-income ratio of 36% because of your mortgage, can you still save for other goals over time? When you buy a home you may also need to budget for maintenance and upkeep of the home, which is not included in the ratios. 

Finally, it is generally a good idea to have at least 20% of the value of the home as a down payment. If your income is high and you think you could afford to pay for a greater mortgage than 80% of the value, you may consider waiting until you have 20% set aside. Having 20% down gives you more financing options and most likely a lower interest rate.

Personal situations

For most people home ownership has value in itself, including a sense of security and being part of a community. That’s why finding out what is important in a home to you should be the starting point of the decision-making process.

Once you have a range of what you would like, a budget with some flexibility, and with the financial ratio as a guide, you should be able to narrow down your search. You may have to go back and forth, revising your list of desirable home features and your budget until you get within a comfortable range.  

In some cases, you may be struggling to stay within your budget after considering competing needs like retirement savings. This can be the case if you live in a high cost area, for example, where you may have to get used to a high housing cost ratio. And it may be OK to have a higher investment in your home if you can plan to use some of that value, later on, to fund your retirement, by moving to a less expensive location or with a reverse mortgage.

As in all investment decisions, your time horizon matters too. A long time horizon allows you to spread some of the costs of buying and selling a home while you accumulate equity. If you think you may stay in a home less than five years, a smaller, easier to sell home may be a better choice. If you plan to live in the house longer, think about features that you are likely to appreciate over time. 

I can’t emphasize enough the usefulness of making a budget in this process. No financial ratio, real estate agent, or mortgage broker can help you figure out what you may be able to pay every month on your house. A good budget can. Not only the budget can help you make a good decision, but it will also provide peace of mind that you are not taking an unnecessary risk to your overall financial health when buying your dream home. After that, happy buying!

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.