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)

Renting vs. Buying a Home

When you’re young, you should start by renting. Quickly save up a down payment and buy a house once you have enough for a down payment. This keeps you from throwing away your hard earned money. This is the traditional advice given to someone my age. However, this isn’t the best advice for everyone.

As usual, I like to use real-life numbers when exploring my options. In this case, I’m going to look at a real rental in my area as compared to buying in the area.

The rental prospect is a 1,640 sq. ft. home with 3 bedrooms, 1.5 baths. This house was built in 1936 and situated in a nice, quiet neighborhood. It’s currently listed for $2,590/mo. The home was purchased in 1999 for $565,000.

A few blocks away we have a 1,550 sq. ft. home with 3 bedrooms and 2 bathrooms. This home was built in 1936 and is listed on the market for $825,000. This house has only been on the market for 20 days, so there’s no reason to think the price is too far off the market at this point. (Update: The house sold for $830,000 within a month of being listed for sale)

From what I can tell from the pictures online, both homes appear similar in condition.

Now, there are many factors that will determine whether it makes sense to buy or rent a home. Some of these factors can be quantified, and others can’t. The pride associated with owning your home can’t be quantified. This is going to be different for each person. Some of you may want to own your own home, while others may want the freedom that renting provides. Renting vs. buying a home will also be largely affected by your career and lifestyle. If you’re not sure where you are going to want to live in five years then it’s not going to make sense for you to buy a home.

There are some nifty tools online that will help you with the math of whether renting or buying makes sense for you. One of the tools I find neat is a graphical rent vs. buy calculator provided by the New York Times. As you can see below, the NYT calculator says that buying will pay off after 19 years. This, of course, is based on a number of assumptions that are simply too hard to predict. The greatest variance is going to come from the annual price change assumption. The safe assumption is the long-run inflation rate, so I used 3%. (To get a better understanding of a long-run appreciation of homes, I highly recommend this post) If I were to change this assumption up to 5%, NYT believes it makes sense for me to buy as long as I plan on staying in the place for 5 years.

Rent vs. Buy House

You have to be careful when looking at these calculators because, if you intend to sell the home after the holding period, you must factor in your selling costs, which are typically about 6-7% of the home’s value. So if I intended on staying in the home for 19 years and selling, I wouldn’t really be coming out ahead. I’d have to factor in the 6% selling costs.

There’s no doubt that most of us either want to, or already do, own a home. It’s the American dream. And the only guarantee when it comes to home prices is the price today. Who knows what tomorrow will bring. If you want a home, and you can afford it, then I think it’s going to make sense for you to buy a home you want. I think the decision is much more personal than any financial calculator can convey. So, some quick rules of thumb: If you want a home, can afford it, and plan to stay there at least 10 years, go for it. If you want a home, can afford it, and only plan to stay there 5 years, then I’d say hold off. Particularly with the current volatility, I’d only buy a home at this point if I intended on being there a while. Whatever you choose to do, as long as you’re aware of the costs and associate risks, any decision you make is going to end up just fine.