Given the fact that my financial planning firm specializes in working with professionals in their 30s and 40s, buying a home is one of the most popular financial goals clients are working towards.
Whether a couple wants to buy their first home together, or an established family wants to purchase a new (and bigger) house with room to grow, determining how to fit this major transaction into their financial plan is a common part of our process.
And the No. 1 question clients ask when they think about buying a home? They want to know how much they can spend.
We try to make sure that focus includes what they can truly afford as well as what makes sense in the context of everything else they want to accomplish with their finances.
To give clients definitive answers, we created two critical guidelines to follow.
1. Keep your housing costs to 20% of your gross income
Our definition of affordability must take into account what you can actually afford and the money you need to have available to fund other needs and goals throughout your life.
That’s why we advise, as a baseline recommendation, to keep annual housing costs to 20% or less of your gross household income.
We consider housing costs to include the principal and interest on your mortgage payment, the property taxes you owe on the home, homeowners insurance premiums, and ongoing costs of maintenance and repairs (which we estimate as 2% of a home’s value per year, on average).
Limiting these housing costs to 20% of your gross income sets up a guardrail that prevents you from maxing out this area of your budget.
Homeownership represents an enormous fixed cost in your cash flow; you don’t just get to decide you don’t want to pay your mortgage one month because you’d rather take a trip. Every dollar you must spend to own and maintain your home is a dollar that can’t go toward anything else you want, your savings, or your other goals.
Other experts do say you can spend much more than 20% of your income on housing and still be fine, and I don’t disagree with that. But my goal is not to set my clients up to be “fine.”
As a financial planner, I want to make sure the strategies and action plans we develop for people include wiggle room and a margin of safety. In other words, we never want to push your budget to the limit and then have your financial life break down if something doesn’t go according to plan.
The trap of spending as much as you can possibly get away with on a home can be especially problematic for people who want to buy more house for something like more kids. In the emotional process of homebuying, they don’t account for the fact that more kids also costs more money, which can really strain budgets if they already maxed out on the house.
2. Aim to save 25% of your gross income to long-term investments
While not specific to buying a house, I also offer this guideline to pair with the spending cap on housing: make sure to save (at least!) 25% of your income to long-term investments.
By “long-term investments,” we mean accounts for retirement (like 401(k)s or IRAs) or investment accounts (like taxable brokerages) that you can commit to staying invested within for at least 10 years.
Money you set aside in “savings,” but that you intend to spend or use to fund goals in the next one to three years, doesn’t count toward this 25% rate because it’s not invested for long-term growth, and that’s the point for the purposes of increasing your assets for the future.
I also encourage clients to prioritize their savings first by making automated contributions and maxing out retirement plans or accounts if possible.
If you can take care of your need to save for the long-term first, it makes it much easier to back into answers for other questions, like how much can you spend on something like a home.
Use these only as guidelines, not hard-and-fast rules
Where the guidelines come in handy is in providing us with a starting point. We can (and should!) always adjust the numbers once we consider the specific circumstances that apply to someone’s individual life.
Your other goals, expenses, needs, challenges, and opportunities all play a role in determining the right balance for you. There are good reasons some people may choose to spend more on housing, and good reasons why other people may want to spend far less.
The guidelines also help by highlighting when…