If you were to look for a new home to buy today, how would you decide what price range to consider? Here are some formulas you might consider:
If you've got ample savings socked away, you may be in the enviable position of being able to pay 20% or more down on a new home. This means you won't have to pay for private mortgage insurance (PMI). So if you have $50,000 at your disposal, you might want to look at homes that cost as much as $250,000. (Note that if you're currently paying PMI, and you've now accumulated more than 20% in your home equity, you can look into getting rid of that PMI.)
Banks often use formulas to determine how much of a loan they're willing to give you. One formula is that they'll let your monthly mortgage payment equal up to about 28% of your gross monthly income. So if you earn $50,000 per year, that's $4,167 per month. Twenty-eight percent of that is $1,167, which is roughly what you'd pay with a 30-year fixed mortgage at 6.5% on a loan of $184,000 for a $230,000 home.
Another bank formula looks at your total debt and other obligations, and doesn't want to see the monthly total (mortgages, credit cards, car loans, child support, etc.) exceed 33% or so of your income.
Keep in mind with all these approaches that it's smart to give yourself a solid margin of safety -- some wiggle room. If you determine that you can swing a $200,000 mortgage, but just barely, consider taking out a $175,000 one instead. Remember, life brings many unexpected twists and turns.
Think also about your current situation, and how you spend your money today. If your rent (or current mortgage payment) is $800, can you stand to replace that with a new monthly payment of $1,200? Remember that home ownership involves many other expenses, too, including taxes, insurance, home repairs, etc.
Fools speak out
This topic was addressed on our Buying or Selling a Home discussion board a while back, where one community member asked about whether you should look above your price range when shopping for a home.
As you'd expect, the responses were mixed. Several Fools stick to their price range like glue. Others argued that because most sellers are willing to negotiate downward somewhat, it makes sense to stretch your range a little. One Fool actually lowballed her upper limit, and found a more affordable home as a result.
Consider putting it off
If you find that you can't afford as much home as you want without taking on a lot of debt, perhaps on unreasonable terms, consider putting the purchase off while you accumulate more money. Renting isn't the end of the world, especially if it permits you to sock away significant moola. I myself rented for about 20 years before buying my first home. It wasn't necessarily the best decision, but it did give me enough time to save up 20% as a down payment on the home.
Meanwhile, if you're going to be renting for at least five or 10 more years, you can invest for the long haul in stocks and funds that have the potential to turbocharge your wealth. If you really want to invest in property, check out a real-estate-related fund. The CGM Realty fund, for example, has racked up an astonishing average annual return of nearly 40% over the past five years. Its top holdings recently included Companhia Vale do Rio Doce, BHP Billiton, Freeport-McMoRan Copper & Gold, and Vornado Realty. (To see a long list of our recommended mutual funds, take advantage of a free 30-day trial of our Motley Fool Champion Funds newsletter.)
If you're interested in home-buying and selling issues, visit our Home Center, which features lots of money-saving tips on mortgages and other issues.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. CGM Realty is a Motley Fool Champion Funds recommendation. Try any of our investing services free for 30 days. The Motley Fool is Fools writing for Fools.