A few days ago CNBC had an analysis where they put out what salary you needed in order to afford a home in 20 cities. Their basic criteria is how big of a salary you needed if you put down 10% or 20%, 4% 30 year mortgage with a 45% debt to income ratio. For example, to afford a median priced home in San Antonio (140k) with 10% down you need a salary of 23k and 20% down you would need only 19k. For each of the cities listed here the house affordability to income was 7 to 1. In other words, you could afford a home (assuming you have the right debt levels) seven times larger than your income.
When I read this article I almost tore my hair out. I mean seriously someone who makes 19k a year, even with 20% down, should NOT be buying a house that costs more than 140k. They probably shouldn’t even be buying a house.
The CNBC article actually confirmed something for me that I thought for a while: banks are allowing people to borrow WAY too much money. For example, I have a colleague of mine who is looking for a home around Boston. One of the banks that he initially went to would have given him a mortgage of over 400k. He doesn’t make more than 90k per year. In other words, his mortgage payment would be roughly 50% of his take home pay. And he isn’t alone.
I don’t necessarily fault him for looking into homes that priced, but after we had a talk I was able to convince him to look for a lower-priced home. Unfortunately, because of the rising cost of living in various places across the country people are WAY overextending themselves in attempting to buy a house particularly in markets like San Francisco, Boston, New York, D.C. and other areas in the country. I mean a 7 to 1 ratio to buy a house is CRAZY. To me there are some better rules of thumb that will make affording a home a lot more reasonable.
Home Buying Rules of Thumb
First, buy a house that is 2 to 3 times your income. One of the traditional rules of thumb, which I still think is a pretty good guideline, is that you should never buy a house that is more than 2-3 times your income. When we were buying our house our mortgage lender specifically told me, “Jason you can afford a lot more are you sure you don’t want to buy something more expensive?” I just about busted out laughing, but I politely declined. The house we bought was less than 2 times my income and allowed me to put our house on a 15 year fixed rate mortgage (now only about 10 years left). I certainly could’ve bought more house, but my payment would’ve been a lot larger and I would feel less economic secure.
Second, only take out a mortgage that is 25% of your take home pay. This rule of thumb is actively promoted by Dave Ramsey. Ramsey advocates that you only buy a house that is 25% of your take home pay that is also on a 15 year fixed term. Dave wants you to pay off the home quickly and have a lot of room in your budget. This certainly isn’t bad (and technically we qualified for both) however a lot of people might not be able to buy a home using this rule of thumb, particularly in high cost living areas (e.g. Boston). Whereas, Ric Edelman (another personal finance guy I listen to) recommends you take a 30 year mortgage that is large as possible. In fact, he wants you to keep it a long time so that you can take the rest of the money and invest it. However, Ramsey’s rule of thumb can be great to pay off your home quickly.
Third, using the 28 to 36% income ratio for buying a house. The 28/36 rule is pretty easy to understand. The 28 part of the rule is that you shouldn’t be spending more than 28% of your gross income on housing. The 36% part is where your housing and your debt payments don’t equal more than 36% of your payments. For example, let’s say you make 60k a year, which is 5k a month. Your combined mortgage payment and other debt (e.g. car loans, student loans, etc. Don’t include utilities, gas, food and other expenses) shouldn’t be more than $1800. If you plan on doing an FHA mortgage you can actually go up much higher. They are willing to calculate your debt ratio up to 43% of your income (e.g. mortgage + your debt payments). The problem with that idea is that the greater debt you have the more in-peril you are in not being able to pay the mortgage. The advantage to that is that it allows more people to buy a home.
Fourth, try to avoid PMI if you can. PMI is private mortgage insurance. Private mortgage insurance is required if you put less than 20% down on your house. PMI protects the bank if you cannot pay the mortgage. However, PMI is usually about $150 per $100,000 on the mortgage. Eventually you can get rid of the PMI by having a loan to value ratio of about 78%. In other words, the mortgage has to be 78% of what the home is worth. By the time most people reach a 78% LTV they have paid thousands, if not tens of thousands of dollars in basically insurance that you could’ve used for something else. If you can avoid PMI do so.
Finally, budget about 1 to 2% per year for maintaining expenses in the home. Generally, I am a fan of home ownership, but that doesn’t necessarily mean it is less expensive than renting. I mean if you rent and you need maintenance you call up the property manager, put in a claim, and they should fix the problem at no cost to you. When you own a home all of the costs are borne by you. Over the past three years we have probably spent at least 10k on home repairs, which is more than the 1% per year in maintenance. If we would’ve been renting we might actually have come out ahead, particularly if you include not paying insurance and real estate taxes. So make sure you realize that things break and you need to take that into account when thinking about buying a house.
The Bottom Line: Home ownership can be great, but DON’T buy a house you can’t afford. Just because the bank will give you a loan for 6 to 7 times your income doesn’t mean you should buy a house that expensive. Follow the above rules of thumb and it will make buying a home that much more affordable. And if that means you can’t afford a home that isn’t necessarily a bad thing. It just gives you more money to save and invest.