“How Much House OR Car Can I Afford?”

Usually the two largest costs families and individuals incur are the mortgage (or rent) and car payment. Have you ever wondered if you are spending too much on your house or car, or what you could afford when purchasing a new one? If you have you’re not alone. Even I occasionally wonder if I am spending my money wisely on these two necessary items. A quick Google search of house or car affordability will yield many differing opinions and advice, some I tend to agree with while others I think are flat-out wrong. Through my research and experiences I have developed a few guide lines of my own to help answer the age-old question “How much house or car can I afford?”

To understand my thought process I need to share my view of affordability, which this statement pretty much sums up. Just because I am able to make a $700 car payment each month doesn’t mean I can afford to do so. When it comes to large monthly payments I find it extremely helpful to have some guidelines for the amount that you allow yourself to spend, ensuring enough income is remaining after these large payments for the rest of the your expenses. Below are two guidelines I have come up with to determine an affordable monthly payment for a house and car[1]:

  • Mortgage (or rent) payment should not exceed 30% of monthly net income
  • Car payment should not exceed 12% of monthly net income

*Bonus guideline built into my assumptions*

  • Savings is at least 10% of monthly net income

The monthly payment is only part of the story however; you should never only consider the monthly impact without taking the total cost into consideration. There are too many different types of financial products which give the illusion of an affordable monthly payment, like the variable rate APR loan. Those factors are the premise for the next two guidelines I developed; a method to quickly determine the total amount of car or house you can afford knowing just your gross income.

To determine how much house you can afford:

  • Take your current Gross Income and multiply by 2.5. For instance if I am making $50,000 per year the calculation would be as follows:
  • $50,000 x 2.5 = $125,000
  • With a $50,000/year gross income one could afford a $125,000 house
    • This rule assumes 6% interest rate, no money down, 30 year fixed mortgage, 1.25% property tax, and .5% PMI

To determine how much car you can afford:

  • Take your current Gross Income and multiply by 38%. For instance if I am making $50,000 per year the calculation would be as follows:
  • $50,000 x 38% = $19,000
  • With a $50,000/year gross income one could afford a $19,000 car.
    • This rule assumes 6% interest rate, no down payment, and 5 year fixed loan

Both rules assume no down payment, so if you plan on putting some cash down add the down payment to value calculated. With the car example above if we planned to put $5,000 down, the total we could afford increases to $24,000 ($19,000 + $5,000).

The reason behind the multipliers, 2.5 for a house and 38% for a car is simple and straight forward. When calculating a monthly payment based upon the results of the gross income calculation and assumptions listed, the outcome will be close to 30% and 12% of net monthly income for income ranges between $25,000 – $125,000 give or take a few percentage points[2].

Utilizing these guidelines has helped me build a strong financial base and limit my financial commitments to monthly payments I know I can afford, freeing up my cash flow for activities I enjoy or extra savings.

Remember, these are just guide lines, not the letter of the law, if your rent payment is 34% of net income don’t sweat it, these guidelines are meant to help build cost awareness and promote conservative spending habits. As long as you’re close to the stated values you are in good shape.


[1] These percentages are not chosen at random, when summed together they equal 52% (including 10% savings) of your monthly net income, leaving only 48% for everything else, food, utilities, gas, etc. Many people make the mistake of spending much more than 50% on their house and car alone, eliminating savings or worse adding debt to cover the rest of their expenses.

[2] When calculating the monthly payment as a percentage of monthly net income I have assumed that net income equals 75% of gross income

Simplify Your Budget, Simplify Your Life

I don’t budget. Well I kind of do, but not in the traditional sense of the word. When people hear budget, they usually envision sitting down and setting up spending limits, line item by line item for every type of expense they can think of. At the end of the process the result is usually something that looks like this (and this is probably short):

There are a few problems with trying to budget like this. One, it takes a lot of time and effort to create and keep up with, two, it’s much too detailed. Attempting to budget for every little expense is a recipe for disaster. Life is random and things change. Some months you may go out to eat more, others you may buy a ton of new clothes. What is the point of making a detailed budget when things change so often?

Here is one example that points out flaws budgeting using this method. Say you have a food budget of $200 for the month and use Mint.com to track your spending. On the 22nd you get a text message stating you are about to exceed your food budget, are you going to stop buying food for the next eight days? Probably not, you will end up going over budget on food and hope to come in under budget elsewhere.

This is no way to operate! What I propose instead is budgeting by type of expense. For this method you need no more than three categories; fixed expenses, variable expenses, and savings. This is how I personally budget and it has been a very effective system since I have implemented it.

So how do you set up a budget like that? Let’s follow an example.

Before you begin

  • You will need three bank accounts, one for each category mentioned above; fixed expenses, variable expenses, and savings, and ideally access to direct deposit through your employer.

1.) Figure out your take home pay (if you are unsure what take home pay is, read this)

  • For this example we will assume net income is $2,800 a month.

2.) Determine what your fixed and required expenses are:

  • These are the expenses that stay the same or are similar every month and you must pay them. Items like your mortgage or rent payment, car payment, etc.
  • Helpful tip, I include my electric, water, and other utility bills in this category even though they may change from month to month[1]. I do this to ensure I will be able to cover all of my required payments and avoid any surprises.
  • Let’s say fixed/required expenses total $1,000 per month, we are now left with $1,800 ($2,800 – $1,000)

3.) Setup a savings goal

  • For this example our goal is to save 15% of our take home pay for the year, this equals $420 a month ($2,800 x 15%)

4.) Calculate the remaining amount, which is our monthly allowance for variable expense

  • Using our example, after fixed expenses and savings we are left with $1,380 ($2,800 – $1,000 – $420)
  • That $1380 is for everything else not accounted for above, dinning out, clothes, entertainment, etc.
  • To get a little more detailed we can divide this number by four to get an approximate limit on how much we can spend on variable items each week, in this case $345.
  • Now all we need to do is spend less than $345 during the week and our budget has been met.

5.) With the amounts calculated above set up direct deposit through your employer so the proper amount goes to each account automatically

6.) No more worrying!

  • Now that your money is automatically categorized and spilt the day you are paid, no more stressing and wondering if there will be enough in the bank enough to cover the car payment, rent payment, or any payment. All you need to do is keep a close eye on your weekly spending limit.

Our revised simple budget for the example now looks something like this.

There you have it, simplify your budget, simplify your life!


[1] The value I use is the highest bill from the previous year plus a few additional dollars as contingency

$100 > $1,000,000 (not a typo…)

I fully intend to have $1,000,000 in the bank one day. Not literally in one bank, spread across many types of investments and accounts, but you get the point. One day, I will be a millionaire.

So many people spend a lifetime chasing what seems to be the elusive goal of becoming a millionaire, only to fail in the end. The thought process usually becomes “if I only made more money” and while making more money certainly helps achieve the goal, it is only half (or less) of the equation. The other half, which is usually widely neglected, is your personal spending habits.

Now, this isn’t going to turn into some published for the thousandth time article that tells you to cut down on the frappucinos, which I’m sure you have read more than once. Instead I am going to share with you one of my personal philosophies on how I think about money.

Regard $100 more than you do $1,000,000

That’s right; treat one hundred dollars today as more than one million in the future. Many people tend to spend $100 without much thought, and a good portion of those will drop $1,000 without much more. And let’s face it, one million is kind of an arbitrary goal to have and probably won’t be enough for you to retire with anyway. Don’t treat saving $1,000,000 like it is impossible and something you will never achieve, think of it in terms of a lifetime and it is actually pretty small.

Millions of people will bring home probably twice that amount during their working lifetime. Think about it, if you bring home a net income of $50,000 a year working for 20 years, you will have made one million dollars. Most people work more than 20 years before they retire and eventually end up bringing home more than $50,000 net per year. Couple this with any income provided by a spouse, and suddenly your earning power doesn’t seem to be the problem.

Read the 1st two paragraphs of this article as some food for thought: http://usgovinfo.about.com/od/moneymatters/a/edandearnings.htm

I could probably make the argument that spending habits actually matter more than income when used to measure a person’s wealth. However, I don’t have any academic studies to reference proving my point…all I need to do is look at the many celebrity actors and music stars who once had millions and are now broke.

Remember when you were a little kid and thought $100 was almost an unimaginable amount of money, what happened to that feeling as we got older? Somewhere along the line it was lost, and the ability to spend freely took over. The next time you are about to make a purchase over $100, do your best to remember that feeling and give the purchase a little extra thought. Is it an item you really need, or really really want*? If you do this, I bet you will see that ever elusive $1,000,000 much sooner.


*Quick Tip: Before buying something you want, wait a week. Or better yet, wait a month before actually buying it. Most of the time the feeling will wear off and you will either not want the item anymore, or want it much less. If you still want it after that time frame and you can justify it, go ahead and buy it. Using this little trick will help you save and cut down on impulse purchases.

Rule of 72

The Rule of 72 is a simple calculation that can be used to estimate the amount of time it will take for an investment to double, no calculator necessary! Well I concede, maybe a basic one…unless you can divide numbers like 3.4 into 72 in your head, in which case, props to you…but most probably can’t, so grab a simple four function calculator and you will be completing compound interest problems in no time!

Example:

I am going to invest $1,000 in a money market account with a yearly interest rate of 2%. To estimate how long it would take my $1,000 to become $2,000 I would divide 72 by the interest rate of 2 (72 / 2). The answer, 36, is about how many years it would take for my initial investment of $1,000 to double. The actual amount of time it would take is 35.003 years, as you can see; using this rule we can get fairly accurate answer with no complicated math!

Bonus uses for the rule of 72

There are two other ways this rule can be utilized. First we can use it to see the effect of inflation on our purchasing power and second, to determine the interest rate required to double an investment in a certain amount of years.

Purchasing Power Example:

The inflation rate is 4% and Jill has $5,000 in her emergency savings fund which earns no interest. She is concerned about the inflation rate and wants to estimate how long it will take for her savings to lose half its value due to inflation. Using the rule of 72 she divides 72 by the inflation rate, 4 (72 / 4) to estimate 18 years. If the inflation rate remains constant Jill can assume in roughly 18 years the buying power of her savings account will be halved. Meaning if she can buy 5,000 iTunes songs today for $5,000 she can expect the same $5,000 in 18 years to only purchase 2,500 iTunes songs.

Interest Rate Required Example:

Bill is ambitious and wants to double his money in 10 years, to figure out an approximate interest rate he would need to invest at he divides 72 by the number of years, 10 (72 / 10) to obtain 7.2. In order for Bill to double his money he will need to find an investment vehicle which yields 7.2% annually for 10 years if he is to achieve his goal.

What is – A Federal Withholding Allowance?

A Federal withholding allowance is the governments way of allowing you to adjust your taxable income, the basis for the federal tax withholding seen on your paycheck. Allowances are claimed on IRS Form W4, (it is one of the forms you must fill out when starting a new job). Some examples of federal allowances are:

  • Dependents you claim on your tax return (ie children)
  • If no one else can claim you as a dependent on their tax return
  • If you plan to file as head of household on your tax return

In the tax year 2011 each federal allowance claimed reduces your taxable income by $3,700.

Example:

Mark is a single male with no children and has a gross income of $50,000/year; he has no pre-tax deductions, making his taxable income also $50,000/year. A few months later Mark gets a new job and needs to fill out his W4, he realizes he was claiming no allowances before, (being just out of college when he filled out his first W4 he didn’t quite know what he was doing) and adjusts to claim 1 (no one else can claim him as a dependent on their tax return). This lowers Mark’s taxable income by $3,700 to $46,300, which also reduces his monthly federal tax withholding, boosting his monthly net income or take home pay.

An important note

You can claim as many allowances as you want on your W4, but this does not change the amount of federal tax owed in a given year. Claiming an allowance only lowers federal income tax withholding, come tax return time if you claimed ten allowances but only two actually apply (the government will check, so will any tax prep software) you will be stuck with a big fat tax bill, owing big Sam all that money which wasn’t withheld from your paycheck. On the contrary, if you receive a large refund you may want to consider increasing the number of allowances claimed, instead of waiting an entire year for that money you will receive a small piece of it every month because of reduced tax withholding.    

What is – Taxable Income?

Taxable Income – The monetary base from which you are imposed a tax. Taxable income for the federal government is usually any income received over the course of the year (gross income) less deductions (such as a federal allowance or 401k contribution) and expenses as deemed allowable by the IRS. Taxable income at the state level is determined by the state’s taxing authority and can differ from the federal government and from state to state.

Simple example: John has a gross income of $50,000/year he contributes $5,000/year to his 401(k) retirement account and has claimed one federal allowance on his W4. In this case John’s taxable income would be $41,300.

Gross Income: $50,000

Less 401(k): $5,000

Less Allowance: $3,700

Taxable Income: $41,300 (this is the number you would use when referencing the IRS withholding tables to determine withholding)

Bottom line, taxable income is the number used to calculate the taxes you owe, whether it is to the federal, state, or local government.

Odds and Ends

So I have decided to add an “Odds & Ends” section to my blog for the purpose of sharing interesting non finance related things I find online and random thoughts of mine. Yes, most posts will be related to personal finance, but I figure why not share other interesting tidbits while I’m at it and have the platform to do so.