I received an interesting question about business, involving optimal payment amounts on rental space. The best I could do was remember the old rule of thumb for paying housing costs each month. In general, it is best to make sure that no more than 1/3 (33%) of your monthly income goes toward paying housing costs. And, really, it’s better if you can get that number down to 1/4 (25%). Mainly because you want to be able to afford other things as well. That’s great if you can live in a really great house or apartment, but do you have enough money to buy things like food? What happens if you hit a financial crisis? Keeping your housing payments down is a good idea, whether you rent or whether you are getting a mortgage.
Rental housing payments
When finding a rental, this is fairly easy. You calculate your monthly salary (I like to use my “take home” since it is a more accurate look at what I have to work with), and figure out how much 1/3 of it is. If you take home $4,000, and divide it by three, you get $1,333. That’s your upper limit for how much you can pay on a rental (in some markets, you might as well buy a house). Dividing by four, to keep your housing payments down to 1/4 of your income, is even better, at $1,000. If you live in a great rental market, like I do, it is possible to rent a four bedroom house for 14% of your income.
When you are looking to buy a house, the same rule applies. Let’s stay with our $4,000 per month example. If you are looking for financing, find out how much you can borrow so that you pay only $1,333 per month on your mortgage payment. Tops. For a mortgage, the closer you stay to 1/4 of your income ($1,000 in our example), the better off you will be. This can usually get you a home that costs between $110,000 and and $150,000, depending on your down payment, interest rate and other fees. How much house this will get you depends on the market (not much house in California, and a pretty decent house in most places in Idaho).
Watch out for financing schemes that get you into “more house.” Some lenders are letting you borrow up to 40% of your monthly income. This can be a very bad thing when all is said and done, as you may not be able to make payments if something happens. Another method is the interest only home loan (read my post about interest only home loans here). Because for the initial period you are only paying the interest, you can get approved for a much bigger loan, since your 1/4 monthly income can make interest payments of $1,000 per month. Of course, none of the principal is being paid. And once the first few years are up, and you start paying on the principal, you could be paying 60% of your montly income on housing payments if you haven’t started earning more.
The best policy is a good, old-fashioned mortgage (with as low an interest rate as you can manage) when buying a house. One that lets you get into something fitting for your financial situation, paying no more than 1/4 of your income per month.