Welcome to another edition of Financial Tip Friday. This post was prompted by a conversation I was having with friend of mine who is thinking about buying a house. Recently, he got pre-approved for a mortgage from one of the local credit unions and his pre-approval seemed to be quite high for his income. He had a nice down payment for a house (upwards of 10%) yet they approved him for almost four to four 1/2 times his income. So it got me to thinking about what are the proper ratios to consider when buying a house.
There are a variety of general thumb rules. One of those rules that I used when buying a house was the 2 1/2 to 3 times rule. In other words, do not buy a house that is more than 2 1/2 to 3 times your income. We actually bought a house that was less than that ratio, which is what allowed us to put a house on 15 year mortgage instead of 30 year. I like that idea because you pay the house off faster.
But there is a problem with that scenario. In many parts of the country housing prices have skyrocketed. Mrs. ROB and I work at universities in the Boston Metro Area. The cover of last week’s Boston Magazine was ‘Can Anyone Afford to Live Here Anymore.‘ The article discussed how difficult it was for people to not only buy a home in Boston, but even to just afford the rent. My friend was considering buying in the Boston suburbs, which is fairly expensive. My wife and me deliberately made the decision to look and shop in another metropolitan area, Providence, RI, where housing is 1/2 of what it is in Boston. In fact Providence is considered to be the hottest housing market in the country at the moment because of the spillover from Boston. Good for us, but for friends of mine wanting to live near Boston the price to buy a condo, townhouse, or home is prohibitive. Unless you have an ungodly amount of money the 2 to 3 times income scenario probably doesn’t work unless you move to something much further from Boston, which is one of the reasons my friend was probably approved for more of a mortgage.
Another common and good rule of thumb is the 28/36 rule. The 28/36 rule basically says that your house payment cannot be anymore than 28% of your gross income and that your total debts should not be more than 36%. For example, if your gross income is $5000 a month than your house payment should not be more than $1400 and your debt should not be more than $1800 a month. That kind of income you can probably afford about a $200000 home. Luckily my friend can afford more than that because he has a larger income, but his overall approval seemed to be more than his income in general.
The 28/36 rule or the 2 1/2 times your income are good ones I think. However, there are some loan programs, like FHA loans, that will allow you to have a debt and mortgage payment of up to 43% of your gross income. In order words, you could be paying, if you really wanted a house, almost 1/2 of your income to a house payment.
That is way too much money. You never know what kind of life will happen.
First, use the 28/36 rule or 2 1/2 to 3 times your income rule to measure what you can afford. However, the key with the first rule is the debt. If you have a lot of debt than the amount of house payment you can afford goes down. For example, if you make debt payments of $1000 with a $60000 income you probably shouldn’t buy a house for more than $100,000 which you will only find in very few markets in the country.
Second, remember a house is just a house. There is no such thing as a perfect house or even a perfect community. One of the considerations for many people are school districts. A person will buy a house that they can’t afford to go into that school district. In my opinion that is just DUMB! You are basically putting yourself one step from financial disaster on chance that you can afford it. If the district is so important than rent or move to another community that might be a little less expensive, but the school district isn’t as bad. Or even better live on the boarder between communities. Many states have open enrollment. By living on the borders between communities your child could go to a good school district, but you find cheaper housing in a cheaper city.
Third, consider all of the other costs of buying a house. A house is NOT always cheaper than renting. People buy houses because they go up and value and they feel like they are “throwing” there money away with rent. However, what people don’t realize is that if your dishwasher, toilet, or whatever breaks down in a house you own you have to fix it. There is no landlord. You are Mr. Fix-it. Most people recommend that you save 1% of the value of the house for home repairs. If you don’t have home repairs then set that money aside. I can’t tell you for sure that renting was cheaper than buying his house. Would I go back to renting….maybe, but with new furniture, repairs, new dryer, toilet, dishwasher, and with new appliances, plus a new circuit box. Mrs. ROB and me have easily spent $20,000 in the past year on those items and it will go up.
Fourth, follow the Dave Ramsey rule of 25%. Dave Ramsey, a personal finance guru, recommends that you spend no more than 25% of your TAKE HOME PAY on a mortgage payment. So his rule of thumb is a little different than the 28/36 rule, which is GROSS income. This rule might force you to buy a smaller house, but it just gives you more wiggle room if it starts raining and it will rain. Luckily, we meet Ramsey’s criteria, but that is only if you include both of our incomes and our extra pay (e.g. teaching extra courses)
Finally, only buy a house if you plan on being there 5-7 years. It will take at least that long to recoup your closing costs and down payment. If you plan on leaving before that. Just rent.
The Bottom Line: I am NOT against home ownership. I am a home owner. What I am against are people making decisions that can put them in a financial pinch. Buy a house that you can afford, even if it is a smaller house. No one says you have to live there forever. Most likely that home will go up in value after a few years. And after a few years you will have paid down your mortgage, increasing your equity, which you could then use to sell your current home and upgrade to another one. Buying a house that you can truly afford and not your so-called dream home is, in my opinion, a much better route to go.