Recently, my good friends Steve and Randy (the parents of two adorable kids) decided it might be time to trade up from their three-bedroom, two-bath town home to a four-bedroom, two-and-a-half-bath house

While Steve has a stable job—Randy stays home with the kids—he is very conservative and spent weeks crunching numbers to determine whether they could afford the move.

When I first heard Steve was putting in all that time, I thought: "Good for him. He's doing everything possible to avoid becoming a causality of the housing meltdown."

But the more I thought it, the more I realized figuring out how much house you can afford, and determining whether now is a good time to be buy shouldn't be that hard.

So, to make Steve's, Randy's, and your lives easier, I set out to simplify the process. My goal was two-fold. First, I wanted to create a hard-and-fast rule for how much you can afford to spend on a house. Like you, I have heard suggestions ranging from 28% to 40% of income, but I have always had problems with that. For one thing, that is an awfully big range. If your family income is \$140,000 a year, depending on which people you listen to it means you can spend anywhere from \$3,266 to ( \$4,666 a month. That's a huge spread. For another, those guidelines apparently don't work very well, as the recent mortgage mess proved.

### Plug In the Formula

My second goal was to see if there is a simple way to figure out, on an objective basis, whether now is a good time to buy.

There is a tremendous amount of information available on housing affordability. For example, the National Association of Realtors (NAR) has its Housing Affordability Index (HAI). This number is designed to track how affordable the average home is at any given moment. It does this by dividing the average monthly household income by the average income a family would need to qualify for a mortgage.

To illustrate how this works, let's take a look at the data for the year ending 2006. The median U.S. family income was \$58,400, and the average qualifying income required to obtain a mortgage was \$54,300. Dividing the family income by the qualifying income, we get a HAI ratio of 108. By itself, this is sort of interesting but not particularly useful.

But let's compare that number with today.

We'll begin by going back to the HAI formula—average monthly household income divided by the income you need to qualify for a loan. We know what our average family income is, right? It's how much we make per year (or per month if dividing by 12).

What is qualifying income, you ask? Good question! According to the NAR, it is the amount you would need to pay your mortgage, taxes, and homeowner's insurance if you put down 20% of the purchase price. NAR says that should work out to be 25% of your gross monthly income. Not only do I like this definition, but I love it that they are using a conservative 25% of income as a rule of thumb for how much you can afford. I have decided to adopt it as my own.

So let's get back to our 2006 example when the HAI was 108.

At that time, the average national home price was \$221,900, and the average 30-year fixed-interest-rate was 6.58%. So, the NAR figured out that if buyers put down 20% (around \$44,000) to buy a \$221,900 home, it would cost them approximately \$1,131 per month for mortgage, taxes, and insurance. That made the income needed to qualify: \$54,288.

Flash forward to today. As of June 30, the HAI, which peaked at 179 in April, was at 159. That meant for the average person, the cost to buy a house was dramatically less than it was three years ago.

Why? Well while the median income was only up slightly—it stood at \$60,671 in June— the qualifying income had fallen dramatically to \$38,160.

What accounts for the drop? Substantially lower mortgage rates for one thing—they stood at 5.16% in June down from the 6.58% three years before—and lower home prices. The average home was going for \$181,900 in June, down from \$221,900 in 2006.

The obvious conclusion: Houses have become way more affordable today.

I know what you're thinking. How could my friends have used this information in deciding whether to buy? After all, what do they care about national averages, all they should care about is their situation.

Absolutely true. Next time, we will talk about how Steve, Randy, and you can put this information to good use.