How Much House Can I Afford?

Home ownership is definitely something that’s in my long-term plan, but I haven’t quite figured out where it fits in. One important aspect of determine when I will buy a house, is determining how much house I can afford. I obviously don’t just want to buy a house for the sake of buying a house, so I won’t be buying until what I can afford aligns with what I want.

The eventual approval for a mortgage is a complicated process, but there are some simple calculations that can be performed to get an idea about how much house you can afford. For example, the FHA publishes its loan requirements on its website. Zillow also offers a quick-and-easy calculation of how much house you can afford. But before you rush off to run the calculation, let’s look at these ratios a bit more.

Mortgage Payment to Income Ratio
Under this qualification ratio, the total mortgage payment (including principal, interest, taxes, insurance, amd PMI) is compared to your gross income as a ratio. This is sometimes referred to as a front-end ratio. The FHA states that it requires a minimum front-end ratio of 31%. You might see 28% mentioned as a common ratio required by private lenders (often expressed as 28/36 debt-to-income — the 36 applies to the next ratio).

To calculate this, you multiply your monthly gross income by the required percentage. For example, if you have a gross income of $8,333 (100,000/12), your mortgage payment should not exceed $2,333 (under a 28% ratio).

Total Debt to Income Ratio
This is where your other debt comes into play. This ratio compares your total monthly payment toward servicing debt with your income. Total debt adds auto loan, student loan, and credit card payments. For U.S conforming loans, the maximum ratio is typically 36%. By taking the difference between the two ratios (8%), you can see that your other debt servicing payments can be up to $666 per month.

Calculating Your Affordable Mortgage
Now that you know what type of payment you can afford, you’ll need to convert this into the amount of house you can afford (or qualify for). If we use today’s rates of 3.5% on a 30-year fixed mortgage, you’d owe about $45 per month for each $10,000 borrowed. You’d have to adjust for any PMI required.

Using the above example:
$2,333/45 = 51.84
51.84 x $10,000 = $518,400

So based on this example income and ratios (which mirror mine), I’d be able to qualify for approximately $500,000 worth of house. And then I’d add any down payment made on top of that.

By comparison, if interest rates are at 6%, then you’d use a ratio of approximately $60 per $10,000 borrowed, which would yield a total mortgage of $388,833.

As you can see, just by being able to take advantage of lower interest rates, I’d be able to purchase more than $100,000 more house for the same monthly payment. I know these aren’t the correct terms to think of as far as home purchases go since the higher 6% loan could potentially be refinanced later, but it’s hard to ignore the huge impact that today’s lower interest rates play.

Is 2013 the Year to Buy a House?

If you’re currently renting then it’s probably a question you’ve asked yourself. Is 2013 the year to buy a house? Purchasing a home is probably the biggest financial decision you’ll ever make, so it’s important to look at the facts in order to keep the emotions surrounding potential home ownership in check.

Housing Market 2013Firstly, interest rates have been low, and continue to remain low relative to historical rates. Your mortgage rate will determine the size of your monthly interest payments, which makes up the bulk of your mortgage payment for the first five years. The lower your interest rate, the lower your monthly payment. In 2012, the average 30-year fixed mortgage rate was 3.88%. Rates are expected to continue to be below 4% during the first half of 2013, and possible ease a bit higher by the end of the year. Now, nobody knows what will happen, but consensus seems to be that mortgage rates will remain reasonable throughout 2013.

So if mortgages rates are currently low and expected to remain low in 2013, it looks like one of the two factors is indicating it’s a great time to purchase a home. Now, let’s look at the other half of the equation: home prices. January 2013 marked the 15th consecutive month of home value gains, according to Zillow. January also showed the largest year-over-year gain since July 2006. Home values rose nationwide, with cities like Phoenix, San Francisco, San Jose, Las Vegas and Sacramento experiencing double-digit gains over the prior year.

I’m hearing word of bidding wars and houses selling for more than their asking price. The main reason for the uptick appears to be housing supply, with the National Association of Realtors reporting an average of 4.8 months supply of existing homes for sale in Q4 2012. In 2010 this had been 10 months, and we’d expect this to be something around 6 or 7 months.

Unfortunately, the supply constraint is being fueled by banks slowing down the foreclosure process and delaying the sale of foreclosed properties. This isn’t anything new, and is certainly in the best interest or banks and current homeowners. Homes that banks currently own on their balance sheets is typically referred to as shadow inventory. According to CoreLogic, the shadow inventory as of October 2012 was at 2.3 million homes, down 12.3% since October 2011. If banks were to try to sell these homes all at once, supply far outreach demand for homes and prices would plummet. By delaying selling, banks are able to artificially deflate the supply of homes, and inflate prices.

Even though home prices are being inflated by banks, there are a number of other indicators that point to strong housing prices in the future. Year-over-year, constructions starts are up, existing home sales are up, and the rate of delinquency and foreclosures has improved. The Trulia housing barometer for January 2013 estimates the housing market to be 50% back to normal, up from 31% of normal in January 2012. These are all good signs for future home prices and point that we may well be beyond the housing bottom of this current cycle. However, with the existing shadow inventory, home starts, and underwater mortgages, I wouldn’t expect home prices to skyrocket.

With low interest rates and stabilized (and slightly improving) home prices, 2013 may be the perfect time to purchase a home. Now comes the most important part of the equation, which is your own financial position. You’ll have to determine what type of home you want and where, and then determine how much home you can afford and how much home you need or actually want to pay for. Sometimes, what you can afford and what you need or very different. Just because you can afford something doesn’t mean you need to buy it. You’ll also need to evaluate whether it makes sense for you to rent vs. buying a home. When I looked at an example in my neighborhood, I saw that it only made sense for me to buy if I was going to stay in the home for 19 years. Yikes!

(Image: Flickr)

Case-Shiller: Home Prices Down in January 2012

The verdict is in for January 2012, and the Case-Shiller index of home prices has now fallen to its lowest level since peaking in 2006. At the beginning of 2011 I had mentioned that it appeared we were heading for a double dip in housing prices. It seems that this has played out and we have indeed double-dipped.

The S&P Case-Shiller 20-City Composite Index reported a 0.8% decline between December 2011 and January 2012, and a 3.8% decline since January 2011. This brings home prices back to levels seen in 2003. This puts home prices still about 35% above their 2000 levels when adjusted for inflation. The below graph shows the Case-Shiller Index pegged to 2000 levels (2000 = 100.00 in index).

Case-Shiller Index January 2012

If you want an interactive graph, I highly recommend the New York Times Case-Shiller Graph.

If you live in or near one of the major cities tracked, then that information might prove to be more interesting and relevant to you. Atlanta was down 2.1% for the month, and a total decline of 14.8% over the last six months. San Francisco was the biggest monthly loser, down 2.5%. However, each of the three California cities tracked (San Diego, Los Angeles, and San Francisco) have not fallen below their 2009 low.

Case-Shiller January 2012 Data Table

I made a table of the data showing 1 month change, change since peak, and change since 2000. It immediately became clear to me that it’s difficult to sort out the affects of the housing crisis, versus the normal demographic affects. Both Atlanta and Detroit are significantly below even their 2000 levels. It’s easy to guess why these cities are below their 2000 levels as people flee those two major cities to move to more desirable locations. It’s also clear the desirable locations with robust job markets have been able to maintain their high values fairly well. Washington D.C. is still up 80% from its 2000 level, and Los Angeles and New York each up 60% since 2000.

Zillow expects that homes prices will stabilize this year. However, keep in mind that banks still hold a lot of mortgages that are in default and should be foreclosed on. I believe that until the inventory of foreclosures has been processed it will be difficult to see any sustained increase in home prices. The banks are smart to not dump all of this inventory on the market because it would depress prices and they would lose big. But until the foreclosure backlog has been processed, I wouldn’t expect home prices to significantly increase.