Why the Affordable Home Really Isn't

by Julie Rains on 3 December 2009 9 comments
Photo: foxypar4

I've taken a look at home affordability calculators that are available from many reputable sites offering personal finance advice. "Affordability" is based on bank lending guidelines rather than real-life budgets. I'll show you a simple formula to help you determine what is truly affordable. And, I'll give you ideas on how your view of affordability may change over the next 15 or 30 years based on typical work/life events.

The Basics of Home Affordability Calculators

Home affordability calculators give a quick-and-dirty estimate of the highest priced home you could buy based on 1) the amount of mortgage loan for which you qualify plus 2) the money you've saved as a down payment. CNNMoney.com explains: "To arrive at an 'affordable' home price, we followed the guidelines of most lenders...Before buying, however, you should also factor in other savings needs, including retirement and college." Translation: you may not have enough money to fund your retirement if you buy an affordable house.

Lender guidelines vary but are typically reported as the following:

  • Housing-to-income ratio (aka front-end ratio) of 28% — Your annual obligation for housing (defined as your mortgage payment consisting of principal, interest, property taxes, and homeowners' insurance) should be equal to or less than 28% of your gross income before taxes. If you earn $70,000 per year and have no debt, then presumably, you can afford to spend $19,600 on housing each year. Note that the housing number doesn't reflect all the costs of homeownership.
     
  • Debt-to-income ratio (aka back-end ratio) of 36% — If you are carrying debt of any kind, then the debt-to-income ratio is considered. The amount you have available to borrow on a mortgage is lowered by your outstanding debt so that total debt doesn't exceed 36% of your gross income.

Note that MSN's home affordability calculator uses a& housing-to-income ratio of .28 (or 28%) for those who have poor credit and increases to .34 for those who have excellent credit. Its debt-to-income ratio is .36 for those with poor credit; .42, excellent credit. As a bonus, this calculator considers closing costs, which improves the realism of the results.

These calculators typically consider the entire mortgage payment (principal and interest plus monthly escrow amounts for property taxes and homeowners' insurance).

The results produced by home affordability calculators are valuable but only as the starting point for determining affordability.

Work/Life Changes with Impact on Home Affordability

The home affordability calculators are based on your income and debt right now. Over the life of your mortgage, it's likely that your personal and/or family budget will change. I can't foresee the future but I can tell you what may happen to the homebuyer-turned-homeowner. These work/life events may increase or decrease the amount of money you have available for your home as well as regular savings, retirement savings, and other expenses.

On the plus side, you might:

On the minus side (financially, not necessarily life-wise), you might:

  • borrow money to buy a car
  • lose a job
  • decide to retire
  • leave a job
  • have children (who can add to your expenses)
  • take a lower-paying job
  • quit a part-time position

 

A Simple Formula

To figure out how much house you can really afford, you'll need the following information:

  • Your monthly budget for a mortgage loan (principal and interest), after other expenses including taxes, insurance, savings, food, etc.
  • Interest rate
  • Loan term (30-year loan = 360 months; 15-year loan = 180 months, etc.)
  • Down payment (what's left of your house savings after paying closing costs)

Then, you can calculate the present value of the stream of mortgage payments and add your down payment to figure out how much house you ought to be able to afford and still buy groceries, take a vacation, and save for retirement. You can use this formula in Excel:

=PV (Interest Rate/12, Loan Term in Months, - Your Monthly Budget for a Mortgage Payment, 0, 0)

or use a web-based Present Value calculator

The tricky part is figuring that monthly budget figure for the mortgage loan principal plus interest. Here are expenses to consider:

  • Income taxes and FICA
  • Retirement savings
  • Property taxes
  • Homeowners' insurance
  • Food
  • Utilities (gas, electricity)
  • Healthcare and dental care
  • Telecommunications / Internet access
  • Clothing
  • Childcare
  • Transportation
  • Home maintenance
  • Life & disability insurance
  • Vacations
  • Student loans
  • Credit card debt
  • Charitable giving
  • College savings

All of these expenses could easily run $60,000, especially for those who hope to save more than 10% annually for retirement and have children. So, someone making $70,000 per year may have about $10,000 to spend on a home. Using the present value calculator, the affordable mortgage may be $155,000 and the affordable home priced at $175,000, given the assumptions that the buyer has saved at least $20,000 and will be getting a 30-year fixed rate loan with a 5% interest rate.

Contrast this number to the home affordability calculators that yield these results (rounded; I've assumed no outstanding nonmortgage loans and annual property taxes/homeowner's insurance to be $3000):

  • Yahoo: $278,000
  • CNN: $278,000-$332,000
  • MSN: $279,000 (using default settings for property taxes/homeowners insurance, closing costs of 3%, and average credit quality)
  • Bankrate: $324,000 (this calculator does not give details on its ratios so I am not sure why this figure is higher than the others)

Each of the calculators is designed slightly differently but tended to yield higher results than my simple formula by using income to determine affordability rather than a carefully-planned budget. If you have significant amounts of non-mortgage debt ($1,000 per month, for example), then the calculators yield much more conservative results, below my theoretical estimate, even if you could service this debt and your mortgage loan. (Though if you lowered the amount to spend on the mortgage by $1,000 to $9,000, then my affordable home would be $160,000, below calculator estimates.)

Stretching yourself for a home purchase may be fine for some, under certain circumstances, such as a great economy with low unemployment and rising home prices. Long-standing assumptions (that is, those made by people when I was growing up) were that you would hold a steady job and receive merit raises of 2-6% every year during your career; if you happened to move for a better job, then you could sell your home and buy a larger house because 1) you now have a larger down payment using your built-up home equity and 2) you're making more money. More recent assumptions were that the home would appreciate in value and that as long as you could make monthly payments, then you'd reap financial benefits of this appreciation when you decided to sell the house and move to a smaller home in retirement. As for me, having graduated from college during a recession, I opted to be more conservative in my home-buying.

If you'd like, share how you will (or did) figure out how much home you can afford.

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Guest's picture

This is a great analysis. During the housing boom I often stood with mouth open and in great shock when I head of some of the prices close friends were paying for houses(given that I had a sense of how much they put down, what they were making, lifestyle choices, etc.) I couldn't believe what the new homeowner thought they could afford. The problem wasn't about banks providing easy money via adjusting rates, but rather what the buyer thought they could afford.

I put together a more qualitative piece on what first time home buyers should consider in terms of affordability here: http://bit.ly/xdQ8N

Best,
Vince

Guest's picture

Your comments are right on the mark! A large part of our current housing crisis was our own doing: Believing what others tell us we can afford. I've read articles about people buying houses they didn't think they could afford without "creative" financing or “no docs” loan approval in the "feeding frenzy" of 2004-2006.

This is not a new experience. As a Realtor in the early 80’s I saw people wanting to buy a house so much they went for the creative financing packages available. It was all predicated on incomes rising and interest rates falling – which they didn’t for a long time.

That was a smaller version of the same circumstances we see today. Apartments were converted to condos. Unscrupulous salesmen were qualifying buyers on the 1st year payments of an adjustable rate mortgage or one where the developer “bought down” the interest rate for a year or more. When the rate adjusted the new owners could not afford the payments. We saw one case where a condo was sold to an elderly woman on a fixed income. Needless to say she lost her home after 2 years.

I returned to real estate in 2006, just as the market started grinding to a halt. Fortunately I was not involved in any of the creative financing then. I do my best to serve as a counselor to my clients. My goal is to keep the joy of buying a home or investment property while maintaining a cool head about the realities of their financial situation. Oh yes - and to make a living for me as well.

Owning a home is a privilege and a great responsibility. Not everyone should be a home owner (hope I don’t get thrown out of the Realtor’s organization for that). Yes, this is a great time to buy but the first question should be is it the right time for you to buy. If your life situation does not allow you to buy now you will miss some opportunities but you may save yourself a lot of heartache by waiting until the time is right for you.

Prices are at or near the bottom in our market but they are not going anywhere fast. This is the time to determine if home ownership is for you. If it is then see what your finances and personal goals in life allow you to spend and limit it to that. There will be appreciation again but it will go back to a much slower rate of 3-4% in a few years. That will allow you to get into the home market, build some equity, improve your finances and buy your dream home when the time is right.

First step is to talk to a mortgage/financial expert interested in long term clients, not quick sales. Next step is to talk to a Realtor who listens and understands your situation. Be loyal to both and you will succeed.

Guest's picture
Jesse

My wife and I are each 29 years old and just purchased our first home in June 2009. We lived on the cheap (and took our time) through college and grad school and had school (for both of us) paid off by the time we graduated. Then we both got jobs, rented for two years and maintained our low living standards while stashing away all the excess money we could for a home down-payment.

In June 2009, we bought a foreclosure (that needed some work, but not a ton) in a great historic neighborhood in Richmond, Virginia for $88,000. According to mortgage calculators, we could "afford" between $200,000 and $250,000. But I agree with you that affordability is extremely inflated when the people telling you your affordability are the lenders and sellers.

We took out a 15-year 4.875% mortgage for $55,000 with the other $33,000 as downpayment. We got the $8,000 from the government and have been throwing more excess money at the mortgage for the past 5 months. As of December 2009, we have $17,500 left on the mortgage. We plan to have it paid in full by June 2010 (12 months after purchasing the house).

I wanted to buy a house with cash (becase that is to truly "afford" something), but it was hard to pass on this deal we got. Thanks for a great article.

Guest's picture

It's almost standard that people end up with a mortgage that they really can't afford. High expectations of future income and rising taxes etc.

Guest's picture
Jake

I used 3 years of tracking expenses/spending habits to find out how much I could spend per month on housing without making much change to the way I had been living. I also did not want to be in debt for 30 years or rely on future raises (there are no guarantees) to help pay it off earlier. I calculated what it would take to pay off in 10 years and this is what I could afford. If I do get any raises the benefit will be I can now pay off my mortgage in less than 10 years.

I could have borrowed $300K but only borrowed $185K.

Guest's picture
Snowy Heron

Article is right - generally ignore all the calculators out there and what the banks tell you you can afford. The rule of thumb that I use is : is your monthly payment 25% or less of your TAKE-HOME pay (not your gross pay)? Given all the other expenses that people have, like cars, kids, groceries, etc, any more than 25% is just way too much. I don't care what the banks say, I will never pay more than that.

Guest's picture

Your percentage is right on. That is what used to be required until all the investors poured money into the market. Old standards were 25% income and no more than 33-35% income minus total debt.

Xin Lu's picture
Xin Lu

Just wanted to say "good for you" to Jesse above.  You got a great deal. 

Guest's picture

Times have changed and you don't want to bite off way more than you can chew. Everybody's job is potentially on shaky grounds, this is how you think even if your job is not this way. You've got to play your finances very safe and have a plan to get out of debt versus gain debt.