In my last column, I wrote about how my house hunting friends, Steve and Randy, could do some basic research to figure out what is going on in the real estate market, in order to figure out whether now is a good time to buy.
It turns out it is. But that fact doesn't help them—or you—if you can't manage to pay for the opportunities out there.
How can you determine how much house you can afford? The best way is to use the same approach the banks do, in figuring out what they'll lend you.
A Key Ratio
I know, I know. The banks are a major contributor to the current financial mess, so why would we use their methods? Well, for one thing, like it or not, they are the ones with the money you need (unless you are going to buy that new house for cash.) For another, since they lost so much money in the housing market recently, they are far more conservative today than in the recent past which means they are less likely to let you buy something that you can't afford.
So, let's look at the banks' formulas. (Most banks use the same methodology when determining how much house a family can afford, so we can generalize.)
While the National Association of Realtors Housing Affordability Index (that we talked about last time) assumes that with 20% down, you'll need 25% of monthly household income to cover your mortgage, real estate taxes, and insurance—the banks start out by being slightly more generous. Most banks lend at favorable rates if monthly costs are around 28% of income. They call this the "housing expense to income ratio."
A Second Look
However, banks also take a second look by adding any other household debt—credit card debt, car loans, college loans, and the like—into their determination. After the debt is added in, they are looking for a debt-to-income ratio of no more than 36% (it was as high as 49% during the housing bubble). They call this the "long-term debt to income ratio."
Let's go back to my friends Steve and Randy and use them as an example. Let's say Steve makes $120,000 a year (I have no idea what Steve really makes). If we divide that by 12, then he grosses $10,000 per month before taxes. According to the banks, assuming Steve has no other debt, he can afford to pay up to $2,800 a month (28% of $10,000) toward a mortgage.
Now it is just a matter of figuring out his other debt, and seeing if the total (including his potential monthly mortgage payments) exceeds 36%.
Two of My Favorite Tools
Instead of getting out the spreadsheets and fancy calculators like my buddy Steve did, a brief search on the Internet reveals many great free tools to both plug in your numbers to determine how much house you can afford and play what if games (what if I put down slightly more; what if I can shave another quarter of a point off the mortgage, etc.)
While you can have fun with all the potential tools out there, let me give you two of my favorites.
The first one is http://www.realtor.com/home-finance/financial-calculators/home-affordability-calculator.aspx. You enter your income, debt if any, and preferred down payment amount, and it will spit out the monthly mortgage, taxes and interest for you, as well as the total amount of house you can afford. I like this one because it is simple, straightforward, and allows you to easily vary several critical factors (such as down payment and interest rate) to see how it would affect what you could afford.
More Helpful Links
Another good calculator is http://michaelbluejay.com/house/howmuchhome.html. It too is simple to use and offers objective explanations about things such as private mortgage insurance and paying points. It also offers helpful links to just about every part of the home buying process.
There's nothing more to it. While two weeks itemizing and analyzing every single detail from his checkbook might have provided Steve with some piece of mind, two hours with these tools would have given him more equal or greater insight, leaving him more time to find his dream home.