Why the Affordable Home Really Isn't
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:
- get a raise at work
- get a promotion and accompanying raise
- negotiate a higher salary or hourly pay
- change jobs for higher pay
- work a part-time job
- turn a hobby into a business
- finish paying student loans
- pay off your credit card debt
- pay off your car loan
- finish school and get a job
- earn a bonus
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
- Utilities (gas, electricity)
- Healthcare and dental care
- Telecommunications / Internet access
- Home maintenance
- Life & disability insurance
- 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.