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:
- 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.
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.
 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.
 When calculating the monthly payment as a percentage of monthly net income I have assumed that net income equals 75% of gross income