As I mentioned in my early retirement post, we would like to buy a house this year. I spent a couple of weeks in the city we want to move to (more on that later) and looked up houses. First, I didn’t have a solid budget; I looked up houses that didn’t seem outrageously priced. After some time, I wanted to start touring the houses. To not waste my time and the agent’s I decided to see if I can actually get the mortgage I was looking for. I figured that would give me a very rough estimate on how much house I can afford.
It turns out I can afford a LOT more than what I wanted. I tried a few prequalify sites and all of them invariably gave me an estimate of 4-5x our annual income. That is not including the 20% down payment. Agreed, it is not actually getting approved but I was shocked nevertheless. So some people actually buy a house that is priced at 5-6x their income? I thought that is what crashed the housing bubble and the banks stopped giving such loans. Turns out getting a 4-5x mortgage is not that difficult according to the real estate agent. The only difference now is the banks are actually verifying the income as opposed to just trusting your word.
At this point, I removed mortgage qualification as one of the factors in figuring out how much house I can afford. I had a number on what I can afford based on our budget, but as this is the biggest purchase we will be making, I had to be sure; really sure that we are not buying above our means. Being a first time home buyer is adding to my apprehension. So I decided to compile all the ways people calculate how much house they can afford. I also added in my own questions to adjust the numbers and decided to go for the lower end estimate.
What is the traditional way to calculate how much house I can afford?
1. Rules of thumb based on debt to income ratio
Estimate based on “front-end” debt-to-income (DTI) ratio, which includes total housing expenses: mortgage principal, interest, taxes, and insurance. According to the mortgage person recommended by my real estate agent, they usually go for 28% in conservative cases and up to 33% in aggressive estimates.
Estimate based on “back-end” debt-to-income (DTI) ratio, which includes all of the above plus other debt payments: auto, student loans, credit cards, etc. Apparently credit card payments that are paid off monthly are not included in this ratio. That seems weird to me, because what if my spending itself is 75% of my income. But I digress, back to the estimate. The conventional limit for the back end debt to income ratio is 36% of your monthly income and the aggressive limits (FHA loans) could be as high as 41%.
Here are some recommended limits on DTI from different players in the mortgage industry (Source : Trulia)
- U.S. Treasury: 31% front-end DTI (debt-to-income) ratio, and less than 55% back-end DTI
- FHA (Federal Housing Administration) Old: 29% front-end DTI, and 41% back-end DTI
- FHA New: 31% front-end DTI, and 43% back-end DTI
- Fannie Mae: 36% benchmark back-end DTI with a maximum of 45% with “strong compensating factors”
- Conventional loans: 28% front-end ratio, and a 36% back-end ratio
Assuming most people go for conventional loans, here are the estimates based on the DTI ratio (I assumed $400 in insurance & taxes, if you want to wary it see the excel sheet attached at the end of this post).
|Gross Income||28% of Monthly Gross Income||36% of Monthly Gross Income||Mortgage (based on the 28% PITI)||Home price (mortgage + 20% down)|
2. Rules of thumb based on annual income
I couldn’t find a consensus on affordability based on annual income. I saw figures ranging from 1.5 x to 5x annual income. For a family earning $50,000 annually, the affordability stretches from $75,000 to $250,000, which is a very broad range, not very helpful. Also this rule doesn’t take into account any other debt and other liabilities.
3. The Dave Ramsey method
Dave Ramsey recommends everyone pay cash for the house. If there is a need to take a mortgage he recommends getting a 15 yr. mortgage and that your monthly payments including mortgage, taxes and insurance not exceed 25% of take home pay. Here is a table of monthly payment and the corresponding affordability estimate based on Dave Ramey’s method. (I assumed 10% of the monthly payment as insurance & taxes, again, if you want to vary this, play with the Excel sheet at the end of the post).
|Gross Income||Take Home pay(Assumption: 30% in taxes)||Monthly Payment||Mortgage(Based on the monthly payments with 3% interest, 15 yr. mortgage)||Home price(mortgage + 20% down)|
Approximating the estimates, Dave Ramsey’s recommendation is 1.5x-2x annual income.
Those are the traditional ways of calculating how much house anyone can afford.
Holes in the traditional ways to calculate how much house I can afford
None of these take personal situations into account. For example, a couple earning $100,000 a year and having employer covered health insurance can afford more than a family of 3 earning the same annual income but having to pay private health insurance and save for a child’s college expenses.
Also a home ownership liability is not limited to a mortgage, taxes & insurance. There is home maintenance, lawn maintenance, cost of furnishing, pest control, utilities and so many other extra expenses that tag along with owning a home. How do we factor in those?
Questions to ask before figuring out how much house I can afford?
I figured the best way to come up with a realistic estimate is to interview myself to spread my financial situation out in the open. When my budget and my goals/priorities are staring at me, it will be difficult to ignore them and put as much money on a house.
What is the overall cost of the house?
We know the obvious cost of the house – Principal, interest, taxes and insurance (commonly called as PITI). What about Home Owners Association (HOA) fee?
- How much will the utilities cost? (I am using my current utilities to extrapolate the charges on a future home. Example: My 600 sq. ft. home costs us on average $60 in electricity, so if we are looking at 1800 sq. ft. home, it would cost us roughly $180.)
- How much should I set aside for maintenance? (Based on my conversation with home owner friends, I am planning to set aside 1-2% every year for maintenance).
- How much will the appliances cost? The ongoing maintenance cost is included in the regular home maintenance, but if the house doesn’t come with any appliances, I estimate we need at least $3000 for a basic stove, refrigerator, washer & dryer.
- Other expenses: If I want to outsource lawn maintenance and home cleaning, how much will these expenses be? It might be a good idea to get some rough estimates for any other anticipated expenses.
How soon do I want to pay house off?
This is another factor that can greatly vary from person to person. 15 yr. and 30 yr. mortgage terms only tell us what the maximum time available is to pay the entire amount back. What if I am someone who is averse to any debt and wants to pay it off as soon as possible? So whatever the mortgage term is, I plan to use the number of years I want to pay the house off as the mortgage term.
What kind of lifestyle do I want after I buy?
I do not want to be house poor. Yes, I can afford a house priced at 5x annual income, but I will have to sacrifice every other expense that makes my life better. I cannot eat out at all or go on vacations. I might not even be able to afford any furniture for the house. I want a monthly payment that will help me pay the house off in 10 years and still let me have a life in those 10 years.
What are the other goals?
Similar to lifestyle, everyone have different goals in their life. I would like to fully fund our kid’s college education and become financially independent by time we are 40. If I buy a house that requires me to keep up my income level for the next 30 years that won’t work for the dreams I have.
Is it reasonable for the area?
I would like to buy a house not just based on my income level but also based on what is reasonable for that area. In California, $500,000 houses are very common. But I do not want a house priced that high in North Dakota. Down the line, I might want to sell the house or rent it out. I want that to be easy. If I buy something way out of the ordinary it will make it that much difficult to rent or sell.
How much debt am I comfortable taking?
Companies might consider 28-41% debt-to-income ratio reasonable, but my comfort level is nowhere near that amount. Right now our rent is less than the conservative amount and I would like to keep it close.
How much house do I need?
This is an entirely different question but according to me a very important one. I might be able to afford a McMansion, but do I really need one? We live in a 600 sq. ft. apartment. We have grown out of it, so we need something bigger, but we do not need more than 1800 sq. ft. (or 3 bedroom/2 bath house). That will make our lives much easier for maintaining, heating and furnishing. We will have enough room for us and an extra room for the guests. That is all we really need.
What are my spending habits or in other words how is my cash flow?
Right now, most of the affordability calculators base the estimate on annual salary. They throw a number on how much they can afford and then expect them to work that number in their budget. Should it be the other way round? Before anyone gets a mortgage, someone sits with their budget to go over their cash flow and then give an estimate on what they can afford realistically?
With all these questions in mind, the only way that comes to mind to accurately determine how much house I can afford is to simulate the experience.
The best way to figure out how much house I can afford: Simulate our mortgage payment experience
Let us say my current rent is $800 and I can afford up to $1000 a month. I want to pay the mortgage off in 8 years. I should open a targeted savings account and start putting the extra $200 right now while I am renting. That will tell me how comfortable I am in spending $1000 a month on housing and whether I need to adjust it down or I can afford to increase it a bit. Assuming I can afford to spend $1000 a month, with an 8 yr. mortgage pay off goal in mind, I know I can afford a house priced roughly at – $100,000. (Check the Excel sheet at the bottom of this post to play with these numbers. It is the second table in the spreadsheet).
How much house did we decide we can afford?
I do not believe in buying as much house as I can afford. Ultimately, it doesn’t matter what anyone else says how much we can afford. (Umm…What is the point of the post then? Well, I wanted to make sure we are not buying more house than what conventional wisdom says we can afford. I wanted to see the lowest estimate out of all the methods to get an idea). Based on our calculations, spending plan, comfort level, needs, goals and priorities, we decided that we can afford 1.5x-2x our annual income (preferably in the lower end of the range).
Mortgage affordability calculator : I have created a mortgage affordability spreadsheet to calculate the numbers above. I will try to convert it to an actual calculator that can be used right within this post, but I need a little more time for that. In the mean time, you can download the spreadsheet and play with the numbers. Some of the cells are read-only because they contain the formula to calculate the home price, change the other cells as needed and the numbers for these cells will be automatically calculated. Let me know if you have any feedback or find any inaccuracies.