How Much House Can You Afford?

The following is an excerpt from Your Money: The Missing Manual, an excellent book written by JD Roth from Get Rich Slowly. Copyright 2010 O'Reilly Media, Inc. All rights reserved. Used with permission. (A sidebar is at the end in red.)

Housing is the largest expense in most families' budgets. But how much is too much to spend on shelter?

Economists have used decades of financial stats to create computer models that predict how much people can afford to spend on housing and debt. Traditionally, lenders have used what's called a debt-to-income ratio (or DTI ratio)—a measure of how much of your income goes toward debt every month—to estimate how much people can afford to borrow to pay for a home. To find this ratio, divide your monthly debt payments by your gross (pre-tax) income. For example, if you pay $300 toward debt every month on a $3,000 income, your DTI ratio is 10%. (The lower the number, the better.)

Banks and mortgage brokers look at two numbers when deciding how much to loan you:

• Front-end DTI ratios (sometimes called housing expense ratios), which include your total housing expenses: mortgage principal, interest, taxes, and insurance. These four factors are often called PITI. (Yes, the mortgage industry is filled with acronyms and abbreviations.)

• Back-end DTI ratios (also known as total expense ratios), which include all of the above plus other debt payments like auto loans, student loans, and credit cards.

When you apply for a mortgage, a computer checks to be sure the amount of debt you want to take on falls within accepted ranges. This process is called automated underwriting. When the computer is finished, the loan application moves to manual underwriting, where an actual person uses industry-standard DTI ratios to decide whether to approve or deny the loan.

Note: The key thing to understand about DTI ratios is that they're used to estimate the lender's risk, not yours. That is, your mortgage company uses them to check whether they think you can make the payments—not whether you can comfortably make the payments. So if you want to be able to dine out and take vacations and pursue other financial goals, the DTI ratio you use in your calculations should be lower than the one your lender uses.

During the 1970s (before credit-card debt became common), DTI wasn't split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance costs were less than 25% of your income, people assumed you could afford the payment. (This is still an excellent rule of thumb.)

Debt-to-income guidelines have relaxed over the years. When my wife and I bought our first home in 1994, our mortgage broker told us our front-end DTI ratio had to be 28% or less, meaning we couldn't pay any more than 28% of our gross income toward housing. The back-end DTI ratio was capped at 36%, which meant that our housing expenses and other debt payments combined couldn't be more than 36% of our income.

When we bought our new home in 2004, the accepted DTI ratios had grown by 5%. "That 28% figure is old," we were told. "Most people can go as high as 33%." The back-end ratio had been raised to 38%–41% in some cases. (During the housing bubble, some lenders went still higher, even above 50%!)

A 5% increase may not seem like a big deal, but when you're talking about a house payment, it's huge. If you're earning $60,000 per year, 5% is $3,000, or $250 a month. Many people have lost their homes because they took on mortgage payments that were just $250 more than they could afford each month.

Generally, banks are happy to lend you as much money as you want. (Within reason, of course, and if your credit is good.) The recent credit crisis has certainly made lenders more cautious, but they're still not going to stop you from digging a hole for yourself if that's what you want to do. In The Automatic Millionaire Homeowner (Broadway, 2008), David Bach writes:

You should generally assume that the amount the bank or mortgage company is willing to loan you is more than you should borrow. […] Don't fool around with this. Do the math. Be realistic about your situation. Don't pretend you're in better shape than you are.

Remember, nobody cares more about you than you. Your real-estate agent, mortgage broker, and bank all have a vested interest in encouraging you to buy as much house as possible—their incomes depend on it. Listen to what they have to say, but make your decisions based on what's best for you.

Homebuyers are often told to "buy as much house as you can afford." But the problem with following this advice is that you're left without a buffer. What if you lose your job? Or what if you're forced to sell your home, but housing prices have dropped? (Many Americans are facing this problem in the aftermath of the housing bubble.) Instead of buying as much house as you can afford, it makes more sense to buy as much house as you need, keeping conventional DTI ratios as ceilings. (The box on Section 10.2.2 tells the story of a couple who bought more house than they ended up needing.)

Ultimately, it doesn't matter what the guidelines are. It all comes down to what you're comfortable paying. Just because conventional wisdom says you can afford a $1,650 housing payment on your $60,000 annual income doesn't mean you should do it.

Give yourself a margin for error. Instead of basing your home-buying budget on a 33% front-end DTI ratio, consider dropping that to 28% or, better yet, 25%. Another way to create a buffer is to base your estimates on your net (take-home) pay instead of your gross pay. You won't be able to afford as big of a mortgage, but you won't feel pinched by the payments, either.

Your Money And Your Life: Movin' on Down

When they got married, Sierra Black and her husband Martin bought a home near Boston, Massachusetts. "We found an old Victorian with gables and staircases and a finished attic." The 2,200 square-foot house was beautiful, and they loved it—but it was a nightmare to maintain that much space. "Buying that house meant buying a piece of the American Dream—but we both figured out pretty quickly that it wasn't our dream."

There was the $2,200 monthly mortgage payment and the $600 monthly cost of their combined commutes (which totaled 160 miles every day). Sierra tried to boost their cash flow by making the sorts of frugal choices described in Chapter 5, but she says, "It felt like I was bailing out a leaky boat with a teaspoon."

After 2 years of struggling to make ends meet, Sierra and Martin moved to a 1,500-square-foot colonial-style duplex closer to his office. "The new house feels small but not cramped," says Sierra. "We gave up a lot of square footage, but we didn't lose any functionality. It turns out we didn't need all that space."

They now pay about $1,600 each month for their mortgage. But that's not the only savings: "All of our utility bills are lower than they were," says Sierra, "and our commuting costs are nonexistent." Martin used to drive 40 miles to work every day; now it's a four-block walk. And Sierra does a lot of her errands on foot. "The great thing about this is that it's saved a ton of money and a ton of time."

As Sierra and Martin have learned, it's not material things that bring happiness, but finding ways to align your spending with your values (see Chapter 2): "Every single day that goes by since we moved, we tell each other this is the best decision we ever made. This improved our quality of life so much."

Comments

[CPA Abroad]

One question about the monthly debt payments. I pay off my credit cards every month, but are my monthly charges considered debt, or is debt the balance you carry? I guess it boils down to lender's definition of debt vs. my definition of debt (if I pay off my credit card in full each month, I do not consider that debt).

[FMF]

CPA --

Yes, I think it does depend on your definition. Technically, anything you owe is debt, so even a balance paid off monthly is debt for a few days. That said, personally I don't count credit card debt that I pay off each month as "debt".

[Strick]

CPA - I don't think it really matters that much. When calculating DTI, the bank would use the "miminum monthly payment" amount for for credit card balance which is usually pretty low for someone paying off their balance every month.

If you want to make sure its not included at all just pay your balance in full the day you fill out any forms so you can truthfully say zero balance, and pay your balance in full the day before the closing date (not payment due date)on your card so it reports zero balance to the credit agencies for that month. I did this when applying for a commercial lease just to make all the ratios/numbers as high as possible.

[Anthony]

@CPA and @FMF:

First, let me disclaimer that I am an "average Joe." This is only my opinion, but... for the purpose of calculating DTI, what you charge monthly will be considered your monthly debt, regardless of whether you pay it off or not.

Think about it this way: What is reported to your credit report? If you charge on credit and pay it off every month, your credit report will still show that you've used your credit card, which boosts your credit utilization, which boosts your credit score. Ultimately, your credit report will used to calculate your DTI. Even if you pay off fully every month, your credit report will show that you have used debt. The lender, in turn, will use that in your DTI.

[Anthony]

I am happy to report that my wife and I decided to buy a house that we would very comfortably afford and only what we NEEDED.

Our front-end DTI ratio is 13.6%, way short of the "suggested" 28% to 33%. If I lose my job or ability to work, our front-end DTI ratio would be 33.8% based on my wife's income solely (smaller of our two incomes). This assumes, of course, my complete loss of income, my inability to work a part-time job, and no disability benefits.

[ParisGirl111]

I like the 25% rule. I am going to apply that from now on to all housing costs whether renting or buying a home.

[Dan]

I think that one of the best points about the story in Boston was the cost of commuting (note that the time spent commuting isn't even a cost in this equation). A study at Brookings concluded that most people who live further away from work don't save money, but they do trade time commuting for square footage. Distance from work seemed to have little impact on individuals combined transportation and housing expenses.

[Squirrelers]

Good lessons learned in this article. Particularly about buying what you NEED instead of "as much house as you can afford", and how having a shorter commute really helps.

In terms of how much to spend on a house, too many people purchase based on the amount for which they have been approved. Not smart. My philosophy is that for most folks, unless you are in the upper tier of earners, buy what you need - not what you would ideally want.

For example: instead of a $500,000 new 4 bedroom McMansion, purchasing a $350,000 20-year old 3 bedroom house just might be enough. Is that extra $150,000 really getting you what you need? Couldn't that be used elsewhere in your life - retirement savings, kids college, emergency funds, etc? What if you lose your job or have health problems, could you cover the costs? What about the increased taxes, utilities, etc?

With respect to commuting: I have had jobs where I have commuted as little as 5 minutes to work (literally walking distance), all the way to 90 minutes to work each way. I can tell you that unless you absolutely have to, or it is significantly better for your career to do so in terms of short-term experience or compensation, do NOT commute this distance. There is a big price to pay in terms of your free time, your health, and your time to spend with family or hobbies.

Living within one's means and having the time to do things you enjoy makes life more balanced.

[wanzman]

I bought my house before I was married, actually about 5 months after I graduated from college. At that time, my front end ratio was right at 30%.

Now that I am married the ratio is 11%, for the following reasons:

- Refinanced 1st mortgage to a lower rate (savings of $100 per month).
- paid of 2nd mortgage that was used to purchase home (savings of $125 per month).

- My income has increased
- My wife works

[Stephen]

My current front-end DTI for renting, in the city of Chicago, is 8%. This has been allowing me to save more than 40% of my income until I do decide to "upgrade" my apartment, or live on my own, as I currently have 2 room mates.

[Dan]

I was aware of these ratios and had computed them myself when we bought our house in 2004. We were well under the limits then, but we're at 8%/16% now. And I feel like our budget is maxed out, although we're pretty good savers. I can't imagine paying over a third of my income for debt.