With rising home prices across much of the U.S. and Internationally, home affordability is top-of-mind for many potential buyers. Given the high price tag, and a lack of formal education on the subject, winging it can be risky. This is especially so for first time home buyers, who don’t have prior first-hand experience to rely on. In this post we will help you really answer the question, “how expensive of a home can I afford?”.
How much have home prices risen?
As of 09/2019, the index is around 14% higher than the prior 2007 high (green line)
Reference: https://fred.stlouisfed.org/series/CSUSHPISA
In simple terms, this means that on average, a $200,000 home at the 2007 peak, is now around $228,000. If you compare the change from say 5 years ago, the price escalation is much more pronounced at around 27%. A home valued at $200,000 in 2014 would now be worth around $254,000. Keep in mind that these are national averages, and the situation would differ by area.
How does that impact how expensive of a home can I afford?
You already know the answer, but looking at the data we can see that homeownership has been in decline since the before the Great Recession (shaded grey area of the graph). It is now back to 1995/2014 levels.
Just in case you were curious where current homeownership levels are in a broader historical context
We can observe that homeownership levels are currently closer to pre-housing boom levels.
So, is now a good time to buy?
To read more about whether now is a good time to buy or not, take a look here: First Time Home Buyer Series: Is Now the Right Time to Buy? A Look at Market Conditions.
“So how much of a home can I afford?” You may be wondering.
Here are 3 different ways to look at this
1) 3x Annual Gross Income Approach
2) Years Worth of Rent Approach
3) Bank Approach (Debt-to Income Ratio, or DTI)
Let’s take a look at each.
1) 3x Annual Gross Income Approach
This is the most straight forward. Take your annual income before taxes and multiply it by 3. Your home should cost less than this amount.
– $60,000/year income = $180,000 home
– $90,000/year income = $270,000 home
– $120,000/year income = $360,000 home
As you may have noticed, the lower your income, the less expensive of a home that you can afford. For many housing markets, $180,000 isn’t going to even buy you a front porch. Joking aside though, this is part of the reason that there will always be a renter market.
That being said, the 3x rule doesn’t mean that you should buy the maximum amount of home possible. I’m more financially conservative, and purchased a home that was 2.2 times my annual income. I sleep well at night knowing that I’m not in over my head. Being able to rent out my home and not go backwards is also another important consideration in my mind when deciding how expensive of a home can I afford.
To learn more about this concept, and many others critical to buying a home from process and timelines, to contracts and massive cost savings tips and resources, check out my First Time Home Buyers Online Course) 100% Satisfaction Guarantee.
2) Years Worth of Rent Approach
I learned about this concept from a best friend in Germany, where it is commonly used as a directional guide in helping you answer how expensive of a home can I afford. You take your monthly housing rent expense and multiply it by a set number of years to determine how expensive a prospective home is priced.
Let me show you using $1,500/month rent as an example.
– $1,500/month rent x 10 years (120 months) = $180,000
– $1,500/month rent x 20 years (240 months) = $360,000
– $1,500/month rent x 30 years (360 months) = $540,000
Using this rule of thumb:
– 10 years rent would be considered inexpensive
– 20 years rent would be considered reasonable
– 30 years rent would be considered expensive
One key difference between the real estate market in Germany and the U.S. is interest rates. My friend is financing his home at 0.9% for a 30-Year Loan. That certainly makes a more expensive home much easier to pay for! The current interest rates here in the U.S. on a 30-Year mortgage is around 4.125% or 358% more!
There is a more scientific approach though, that lending institutions use, and that I think is the best way to know where you really stand in terms of affordability.
Let’s dive in.
3) Debt-to-Income Ratio (DTI)
Figuring out your debt-to-income ratio may sound intimidating, but it doesn’t need to be. It is one way that financial institutions determine how expensive of a home that you can afford by looking at:
1) the percentage housing represents of your gross income, and
2) the percentage housing and total debt combined is of your gross income (pre-tax income).
Let’s break it down.
Front-End Ratio
– Total % of gross income that goes towards housing, including monthly mortgage payment, home insurance, property taxes and home association dues
– Should typically be less than 28% of your pre-tax household income
– HUD/FHA requirement is that the maximum allowable to qualify for their loan programs is 31% of gross income
– For example, if you earn $5,000/month, then 28% of your income would be $1,400. That means that you would need to spend up to a maximum of $1,400/month on a mortgage. That number includes home insurance, property taxes, HOA dues etc.
Let’s break that down further.
Assuming a home purchase price of $250,000 and an interest rate of 4.125% (assuming a “Good” credit score), here is one possible scenario.
Scenario 1: Paying 20% Down
- Monthly Income = $5,000
- Loan Amount = $200,000
- Down Payment = $50,000
- Monthly Loan Repayment = $1,371 with home insurance and taxes* (actual will vary, so check for your area)
- $969 Principal & Interest
- $169 Property Tax
- $233 Homeowners Insurance
- HOA = $0 in our example
- Front-End DTI Ratio = 27.42%
Scenario 2: Paying 5% Down
- Monthly Income = $5,000
- Loan Amount = $237,500
- Down Payment = $12,500
- Monthly Loan Repayment = $1,652 with home insurance and taxes* (actual will vary, so check for your area)
- $1,151 Principal & Interest
- $169 Property Tax
- $233 Homeowners Insurance
- HOA = $0 in our example
- Front-End DTI Ratio = 33.04%
As you can see, there is a tradeoff between paying down more or less. If you have the savings to pay 20% down (and closing costs, home inspection and other out of pocket expenses), then you would likely qualify for the loan based on the Front-End Ratio criteria.
However, if you only pay 5% down, then your monthly payment of $1,652 would exceed the Front-End Ratio criteria (at both the 28% and 31% threshold levels).
However, make sure that you don’t put all of your savings into your downpayment though. You will still need 1-3% for closing costs ($2,500 to $7,500 in our example), money for home inspection and other miscellaneous expenses, as well as reserves in case you lose employment.
QUICK TIP
– Work backwards from your current income to see what level of financing you may qualify for
– Take your pretax monthly income, say $5,000 and multiply it by the threshold percentage limit, let’s use 28% to be on the slightly safer side ($5,000 * .28 = $1,400)
– Your mortgage, home insurance and taxes need to fall within that range
– Know what your credit score is using a free site like credit karma, or through many of the credit cards that offer the service free of charge
– Use a mortgage calculator like this one from nerdwallet with PMI to know what you can likely expect in terms of a monthly expense
– When you’re serious about buying a home in the next 2-4 months, contact lenders to get a better picture what actual terms will look like for your situation
Back-End Ratio
– Amount in Front-End, plus all other debt payments, such as student loans, car payments, child support, credit card debt etc
– HUD/FHA requirement is that the maximum allowable to qualify for their loan programs is 43% of gross income
– Using our same $5,000 gross income/month example, at 43% of gross income, we are now able to qualify for up to approximately $2,150 for monthly housing payments.
Let’s take a look at a previous example, adding in $800/month of total debt repayment (across student loans, car payments and credit card debt).
Scenario 3: Paying 20% Down Introducing Debt
- Monthly Income = $5,000
- Loan Amount = $237,500
- Down Payment = $12,500
- Monthly Loan Repayment = $2,452 with debt repayment, home insurance and taxes* (actual will vary, so check for your area)
- $1,151 Principal & Interest
- $169 Property Tax
- $233 Homeowners Insurance
- $800 Monthly Debt Repayment
- $99 Private Mortgage Insurance
- Essentially wasted money for you that insurers lender in case you default
- Typically required for down payments less than 20%
- Notable exceptions are VA Loans, FHA Loans and some others
- There are other workarounds, but that is beyond the scope of this post
- HOA = $0 in our example
- Back-End DTI Ratio = 49.04% (over the limit)
To make this scenario work, the monthly debt amount would have needed to be closer to $450/month. While you can somewhat game your monthly debt repayment amount by re-financing for a longer term, I wouldn’t recommend it for most people as the basic economics haven’t changed. That home is just too darn expensive (sure looks nice though!).
It is important to know where you stand up front and early on in the process to save yourself time and heartache from looking at properties that are too expensive for you.
Is the Debt-to-Income Ratio the end all be all?
While a helpful starting place, as a financial conservative, I would recommend that you shoot well below the maximum limits if you can. In my personal situation, my DTI is closer to 18% on the front-end vs. the maximum limit of 31%.
I bought a less expensive home than I could afford, because
A) I don’t think having most of your net worth wrapped up in your primary residence is a winning strategy, and
B) More expensive homes = more expensive housing payment = worst case scenario, you have to move and need to rent the property out, you would lose money every month before you ever factor in more expensive insurance, property management, vacancy etc.
Final Word: Don’t Blindly Trust Online Affordability Calculators when answering the question “How expensive of a home can I afford?”
When I was researching buying a home, I used well respected Personal Finance websites to try and initially understand how much of a home that I could afford. When the calculator told me $462,000, I knew it was wrong and that I needed to give in deeper and figure this out myself.
I ended up buying a FSBO (for sale by owner) property without an agent (because I found the property myself and had educated myself at this point) to help the seller avoid the broker’s commission, and to help me get a more competitive price. After going through the whole process and buying well, I bought under market value, I wanted to create a resource for people who A) aren’t Analysts to spend countless hours figuring things out, and/or B) who didn’t have or want to spend the time to get there.
That is why I created my online First Time Home Buyer Online Course, to help people get a fundamental understanding of the process, as well as their own financial situation, because really, no one else will do it for you. Nor do they have to face the consequences if you get it wrong (think subprime mortgage crisis).
Let’s be real for a second, and look at how the key players in the real estate market are motivated and incentivized:
– Bankers are there to loan you the maximum amount their lending department will approve (that’s how they make money)
– Real Estate Agents are going to ask what your budget is, and how expensive how a home you are approved for and find you a home in that approved price range (also how they make money)
It isn’t either of their jobs to:
– educate you on your financial situation
– tell you what is a smart amount of money to spend on a house
– determine your risk appetite
Some great bankers or agents will help you along the way and take the time to educate you thoroughly, in my experience though, they are unfortunately in the minority.
