Can’t decide whether to rent or buy your next home? We recommend going back and reading Part I of this blog series. If you’ve already decided to buy, you might be asking yourself how much house can I really afford? The first step should be to determine your budget for home shopping. This can be determined using a number of factors, including maximum monthly payment, upfront capital requirements, and mortgage financing. After that comes the fun part of shopping around to buy a townhouse, single-family home, condo, or anything else!
DETERMINING YOUR HOUSING BUDGET
So, you're thinking about buying a house. But you have questions…
- Should I buy a house right now?
- Can I afford to buy a house right now in relation to my other goals?
- What’s a realistic price range for my home purchase goal?
These questions are 3 of the most commonly asked among potential home buyers, by far. There are several ways of arriving at the answers.
In Part I of our Home Buying series, we discussed some of the reasons why you might want to rent your next home versus purchasing it outright. Today, we’ll dive into affordability and how you can arrive at a realistic budget that won't leave you house poor.
/ adjective /
- A house poor individual is anyone whose monthly housing expenses account for a very large percentage of their monthly budget. Individuals in this situation are often short of cash to cover other items and tend to have trouble meeting other financial obligations, such as car payments or education costs for children. Alternatively, this can be a person who uses most (if not all) of their after-tax cash and investments for purposes of meeting their home down payment requirements. House poor individuals can often be forced to limit discretionary expenses, carry balances on credit cards, dip into savings, sell other assets, or downsize in order to meet their financial obligations.
Disclaimer: We are certainly not attempting to dissuade anyone from pursuing their dream home purchase! The perfect home can provide things that money can't buy; such as security, control, belonging, community, identity, and privacy. Not to mention the consistency of not having to move as frequently. Life is often about tradeoffs, and people stretch their home buying budgets all the time. Our job is to lay out all of the factors!
Affordability is among the top reasons why first-time homebuyers stay away from their dream of owning a home. In fact, housing affordability is so high on their list, that it ranks higher than the fear of not being able to sell the home they eventually buy. But don't worry! There are steps you can take to ensure that you find an affordable house that meets your needs.
Whether or not to rent an apartment, buy a single-family home, or buy a condo is hard enough. There are a number of tradeoffs and considerations, but that’s a conversation for a different blog post!
Let’s examine affordability, which typically comes down to two main items:
1) How much is the house going to cost per month?
2) How much is the house going to cost upfront?
The question is, would they even qualify for a loan that's large enough to purchase that home based on their credit and income? Furthermore - should they take on the financial commitment of the home based on their goals and other expenses?
When you’re looking to establish a maximum home purchase price range, there are three key things to take into consideration:
- Down payment and closing costs
- Monthly housing payment
- Total debt-to-income ratio (DTI)
THE MAIN WAYS TO ARRIVE AT YOUR MAXIMUM PRICE
Let's assume the following facts for this scenario:
Who: Married Couple
Location: Washington, DC
Gross Household Income: $250,000
Credit Scores: 815 | 800
Desired Price Range = $800,000 - $1,000,000
Down Payment % = 15% or more
Liquid After-Tax Funds Available = $200,000
Using those facts as a baseline, we'll follow steps A through E as outlined below:
A. Determine the maximum monthly housing payment based on the % of your gross income.
For years, a general rule of thumb has been to keep your monthly housing costs to approximately 30% or less of your gross income:
This concept was developed in the 1930s when the government began measuring housing affordability. It was originally lower, but by 1981, 30% became the standard. Americans who spend more than 30% of their pretax income on housing costs, including insurance and property taxes, are considered "burdened." The calculation is based on the cost of other goods and services, like groceries, healthcare, and education.
Mortgage lenders can be even stricter — many don't like to see a potential homeowner spend more than 28% of their income on housing.
Most people cannot afford to buy a house outright for cash. Right now, the median home price in the US is ~$415,000 and if you live in a larger metropolitan area, that number is likely 2x - at least! The solution is to finance the home by taking out a mortgage loan.
B. Determine the maximum monthly housing payment based on the debt-to-income (DTI) ratio.
Next, we have the debt-to-income ratio (DTI), which is simply the percentage of your monthly income that goes towards paying off your various debts. This number can be used to determine whether or not you are financially stable enough to purchase a home and qualify for a mortgage loan. The lower this number is, the more likely you are able to qualify for a loan and buy a home with good financing terms.
The debt-to-income ratio (DTI) is a measure of housing affordability that takes into account your total debt payments as a percentage of your income. It's generally considered ideal to have no more than a 28% ratio, but some lenders may consider up to 36%. The lower your DTI number, the better.
Income includes any of the following
- Pre-tax monthly salary (determined by dividing your annual salary by 12)
- Income from additional jobs or side hustles
- Income from rental property or other investments
- Regular income from annuities, trust funds, and retirement accounts
- Any child support or alimony payments you receive
Using our same DC couple, here are some additional facts about their monthly income and debt commitments:
Student Loan = $400/mo.
Auto Loans = $900/mo.
Personal Loan = $100/mo.
Total = $1,400 monthly debt obligations
Pre-tax combined salary = $20,000/mo.
Side hustle = $835/mo.
Total = $20,835/mo. gross income from all sources
Current Debt-to-Income Ratio = 7% ($1,400 / $20,835)
Maximum Additional Debt to Remain Below 36% DTI = $6,100/mo.
Implied Maximum Mortgage Payment (PITI*) = $6,100/mo.
*PITI = Principal + Interest + Taxes + Insurance
The following graphic calculates what your maximum monthly mortgage payment should be based on your income and existing debt obligations:
Minimum payments for all outstanding debts + potential new mortgage P&I divided by your total household income should be less than 36%.
Maintaining a reasonable monthly housing expense is very important! You will want to maintain excess cash flow for other necessary (and fun) expenses while allocating dollars towards other savings goals such as travel, college funds, and early retirement savings.
C. Factor in other monthly housing expenses and back into the maximum principal and interest payment.
Earlier in Parts A and B, we looked at the maximum monthly housing payment based on a 1) percentage of income and 2) debt-to-income ratio.
The next step is to consider all of the other expenses required to own a home.
Note: This is where you may have to make assumptions about things like property taxes, HOA, insurance, and utilities.
Monthly payment inputs:
- Loan Principal
- Loan Interest
- Property Taxes
- Homeowners insurance
- Utilities & Repairs
From the $6,100 maximum payment we calculated in Parts A and B, we have to then subtract additional expense assumptions for real estate taxes, homeowners insurance, homeowners association dues, and utilities in order to arrive at just principal and interest:
D. Determine feasibility for the amount of downpayment and closing costs required upfront.
A down payment is the amount of money you pay upfront when buying a house. It's usually a percentage of the total cost of the home, which means that it can range anywhere from 2% to 20% depending on your purchase.
Your down payment can be as low as 0% for a VA loan or 3.5% for FHA loans, but those mortgage options are reserved for a special subset of the population. In 2021, the average down payment was just 7% for first-time home buyers, and 17% for repeat home buyers.
Downpayment (Typically 5% - 20% of purchase price)
- 20% is the most common to avoid PMI (mortgage insurance charged by the lender - increases your monthly payment
By putting down a smaller % payment upfront, your monthly payments will be higher, you’ll have less equity in your home to start with, and will likely be subject to Private Mortgage Insurance (PMI) as part of your monthly payment obligation. We recommend putting down as much upfront as you can with 20% as a default, but it often depends on the magnitude of the home in question.
Down payments might be made in cash or through a loan (using an FHA-insured loan). The latter option has become much more popular over recent years due to its lower rates and easy qualifying standards. If you opt for this route, it is important that anyone who contributes towards making your home purchase possible knows what they are getting into: they will have some responsibility should anything go wrong while owning this property (e.g., being liable for any damage caused by their guests).
$850,000 house = $170,000 down payment (20%)
Potential sources of down payment:
- Cash on hand (checking, savings, money market, CD's, I-bonds, etc)
- After-tax investment accounts (brokerage)
- Up to $10,000 from a qualified retirement plan (first-time home buyers only)
- Gifts from family members
Another item that many people forget about is closing costs! Depending on the price of the home, these expenses can be significant. Our example couple in DC would likely pay around $3,000 in fixed closing costs, and 3% - 6% in variable closing costs. We've used the higher end of the range for this example (6%). From the fact pattern earlier in the post, we know the couple would like to put down at least 15%:
It is also important to consider the “safety” of the dollars held for the down payment and closing costs leading up to your home purchase. If any portion of your down payment is currently invested in stocks or riskier investments, we recommend shifting those assets to a high-yield savings account or very short-term bonds at least 6-8 months before your targeted home purchase.
This will help avoid the worst-case scenario: you find the home of your dreams, but the money you had earmarked for a down payment loses 20-30% in a down stock market right before you make the offer!
E. Consider the mortgage financing and back into the top end of your budget range!
Based on the underlying math, this couple should ideally aim to purchase a home that requires a maximum principal and interest payment of $4,500/mo.
Lastly, we can mathematically back into the maximum total home value based on the principal and interest payment. We've used a 30-year Fixed Rate mortgage as the most common form of home borrowing, but note that there are several other options including 15-year Fixed Rate, Adjustable Rate Mortgages (ARM), Jumbo Loans, Conventional Loans, Government-Insured, etc.
Based on this couple's goal of purchasing a home in the $800,000 - $1,000,000 range, we would say that they are in good shape to go shopping and approach it from a very well-prepared position! As we've seen in recent years, the real estate market has continued to be extremely competitive. Homes often sell for significantly above the original asking price, multiple buyers compete in bidding wars, and wealthier buyers can come in with "all cash" offers which are often preferred from the seller's perspective.
Having a great real estate agent and mortgage broker can make all the difference, and we'll discuss the total home buying process in the next segment of this home buying blog series.
Based on a comparison of all of these factors, you can weave your way through the numbers to arrive at the ballpark price range you should be considering when shopping for your dream home.
Before embarking on the purchase of a new home, list your requirements for your new house, make a plan, and decide on a budget and timeframe. Then research your home loan options and choose the one that is the best match. Go for a prior inspection and if it’s your first time, don’t hesitate to ask for professional advice and soon enough your dream home will be all yours!
Part III of our Home Buying series will take a look at the complete home buying process. We’ll cover everything from the moment you begin looking at homes in your area, all the way through signing the final closing documents and getting the keys!
Range is here to help.
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