If you are in the market for a new home, especially your first one, you will be faced with a plethora of choices and decisions to make.  Location, size, style; there are so many variables that you may find the process overwhelming.  But the first decision you will face is how much house you can afford.  And if you approach that question the way most people do, the answer you come up will most likely be wrong.

Usually it’s a real estate salesperson to whom you will turn to address the budget question.  And he or she will typically help you calculate the amount based for the most part on how much you can borrow.  Lenders calculate several debt-to-income (DTI) ratios to determine the maximum amount they are willing to lend you and the interest rate they will offer.  One commonly-used ratio is a comparison of your monthly house payment (including principal, interest, taxes, and insurance) to your monthly gross income.  Today lenders limit this ratio to less than 28%.  So as an example, if you are making $120K annually, you would have a gross income of $10K per month.  Therefore your monthly mortgage payment would be limited to $2,800.  If your credit score is such that you qualify for a 30-year loan at 4%, the maximum loan amount would turn out to be $586K.  There are additional ratios that lenders use that might further limit the loan amount, but this is basically how it works.

Continuing with the methodology, to determine the maximum affordable house, you then need to add the down payment.  If you’ve got $100K sitting in your bank account, you could afford no more than a $686K house, including sales costs and other fees that are part of the house transfer process.  (Lenders also have minimum down payment requirements, typically from 10% – 20% these days, but in our example you would have more than enough).

But this is all quite beside the point.  The analysis above wasn’t designed to help you figure out how much you can afford.  It was really to help the lender mitigate the risk they are taking when loaning you money.  In other words, it was for their benefit, not for yours.  There’s no guarantee that if you do purchase that house, you won’t run into a cash flow problem in the future.  While that might be a problem for the lender, it would be a problem for you. What if it turned out that you were able to continue to pay for the house, but due to cash flow constraints you were forced to cut back on dining at restaurants, to give up your SF Giants season tickets, and to tell your daughter that she can’t participate in that school trip to Washington D.C.?  The term for that is “house poor.”  How would that affect the quality of your life?

The most effective way to determine how much you can actually spend on a house is to create a financial plan before beginning your home search.  A good plan will take into account your cash flow, the other goals in your life for which you will be spending money in the short, medium, and long-term, your retirement expectations, your current savings, and your expected savings throughout the rest of your life.  Once you combine all that data, the amount you can spend on the house can easily be determined.  You can even compare various mortgage options so see which would be optimal.  What makes this approach so powerful is that it will change the context of the house purchase decision from “how much can I borrow” or “how much can I spend right now” to “how much I can afford while leaving myself enough money to be able to do everything else I want to do for the rest of my life.”

It is not the role of real estate salespeople to create financial plans.  You need either to do it yourself or to hire a Certified Financial Planner™ professional to do it for you.  Either approach will take time and possibly involve cost as well.  Is it worth it?  Well, which would be worse:  to discover that you cannot afford a house before you buy it?  Or afterwards?