How Much House Is Affordable?

Apr 18, 2014 by

homeA special treat today: a guest post by Tali Wee of residential real estate titan Zillow. Enjoy!

Home shoppers beginning their searches often struggle with where to start the process. Before addressing the important home qualifiers such as location, number of bedrooms and a master list of must-have features, shoppers should carefully evaluate how much home they can afford. Once buyers settle on their maximum spends, they can really begin qualifying neighborhoods and property specifics.

As buyers shop for homes they can calculate housing expenses to get an idea of how much each mortgage might cost monthly. The general rule for affordability is a buyer’s mortgage, taxes and insurance combined should not exceed 25 to 28 percent of his or her monthly income. However, buyers should assess a handful of other factors to determine how much they truly can afford. Here are five additional components for buyers to calculate.

1. Disposable Income

First-time buyers who currently rent are accustomed to their monthly rents and lifestyles. Typically, rents are less than mortgages, and almost always less than the total costs of homeownership. In homes, utility bills increase due to the size of the property and all maintenance becomes the homeowner’s responsibility. Therefore, first-time buyers have to alter their spending habits to meet their new bills. Evaluate budgets to identify the best places to cut corners. If buyers aren’t willing to give up nights out or other expenses, they should only search for homes costing close to or less than their current rents.

2. Debt-to-Income Ratio

Another guideline to help identify how much buyers can afford is their debt-to-income ratio (DTI). To calculate DTI, add up the cost of housing expenses (monthly mortgages, taxes, insurance) plus all other monthly obligations such as minimum credit card payments, student loan payments, car payments, etc. Buyers should then divide that sum by their gross monthly incomes. The resulting percentage is the buyers DTI and should not exceed 43 percent of his or her monthly income. As a general rule, conventional loan buyers need a DTI of 36 percent and FHA loan buyers, 41 percent. Buyers with higher DTIs should work to reduce debt before buying a home.

3. Credit Score

A buyer’s credit score is a major factor that dictates the mortgage interest rate offered by the lender. Higher interest rates make borrowing money from the lender more expensive, and therefore create higher monthly mortgage payments. Buyers with interest rates of 740 or above are offered the lowest interest rates available. If buyers have low credit scores, they should work on raising them before buying a home. Otherwise their loans will cost more and they’ll be able to afford less.

4. Down Payment & Closing Costs

Down payments range between 5 and 20 percent of the total value of the home. Homebuyers who want to avoid paying private mortgage insurance (PMI) should be prepared to pay the full 20 percent of the price of the home as their down payments. PMI is insurance paid to the lender to protect the lender’s investment; it’s paid by the borrower until he or she has 20 percent equity in the home. In addition to the down payment, buyers pay closing costs of 2 to 5 percent of the home’s purchase price. It is negotiable for the seller to cover a portion of the closing costs, but first-time buyers calculating affordability should factor in potential closing costs.

5. Maintenance Costs

Buyers can assume annual maintenance costs of 1 to 4 percent of the total price of their homes. Each year homeowners have to pay for upkeep on their properties from big ticket items such as replacing the roof, windows, water damage or HVAC system to smaller repairs including adding attic insulation, painting, replacing a screen, light bulbs or filter. All of these basic maintenance costs add up quickly and they’re entirely new costs for first-time buyers who are accustomed to their landlords paying for maintenance.

Though affordability is entirely circumstantial, prospective buyers can use these guidelines to evaluate their budgets, calculate their DTI and potential interest rates while accounting for closing costs and future home repairs. When all of these steps are balanced and compared to the expert recommended percentages, buyers have a great baseline to begin home shopping.

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  • These are great things to consider. I know MOST people buy a home that they cannot afford. My wife and I did. Maintenance costs and utilities are big things that people don’t consider.

    • I think you’re right Kalen. One reason is that realtors encourage buyers to discover how large a mortgage they can possibly qualify for, then they show houses only at that level and perhaps a bit more. The conventional wisdom seems to be we should max out whatever borrowing capacity we have. The consequences of this philosophy are easy to see in society.

      What we can afford and what we can qualify for are two totally different questions. The latter is irrelevant, in my opinion. I’ve written about my thoughts on how one can determine what’s affordable–whether a house or anything else–here: http://mymoneycounselor.com/can-we-afford-this

      • That’s exactly right! Oh this is what you want? I think you really want a little more. lol Flippin’ salesmen.

  • I received an emailed comment on this post; I’m transferring it here to allow reply by the author and for others to read and consider.

    “I believe that Mr. Wee’s analysis requires clarification. In his second paragraph he states that “The general rule for affordability is a buyer’s mortgage, taxes and insurance combined should not exceed 25 to 28 percent of his or her monthly income.” If the assumption is that the buyer is either a man or a woman, this may be an appropriate statement. However, if the “buyer” is a couple, is he referring to their combined income? If so, I suggest that a further discussion may be needed.

    When a couple buys a home, they often (usually?) obtain the maximum mortgage they can “afford”. If, or when, a few years later, one or the other becomes unemployed, that income is no longer available to meet the original financial obligation which was based on two incomes. Given the recent increases in job losses among Americans, it may be prudent to take into consideration how long-term unemployment by one of the family’s income producers might affect their ability to continue meeting financial obligations initially determined by two incomes. Perhaps this possibility should be factored into the decision-making process when determining how much house they can afford.

    Of course, it is also possible that a single home buyer might become unemployed for an extended period. Factoring potential future unemployment into the home buying decision for this person becomes more difficult, if not impossible.

    Archie “

  • Student Debt Survivor

    This post is coming at a good time for us as we’re considering selling out condo and buying a home in the suburbs. We’d actually like to spend a little less this time and are hoping to find a multi-family so that our renters could help us pay down the mortgage (well basically they’d pay our taxes).

  • addvodka

    One expense with respect to our house that really surprised me was the maintenance costs. We budgeted for maybe only 60% of what they really are. Yard maintenance is not cheap. We can afford it, but we’d prefer of course not to spend as much.

    • I think a lot of, especially first time, buyers underestimate maintenance. Not only can maintenance costs be large, often they’re unpredictable, compounding the challenges to managing a household budget.

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