ratios for determining how much house you can afford

Two weeks ago, I featured a home-buying inographic that presented a few ways to begin to understand how much house you can afford. There are several different ratios out there to consider when first determining what you can afford and I wanted to break them down a bit.

1. Price to Income Ratio - This ratio takes the price of the house and divides it by an individual's annual income. The national ratio (median home price/median annual income) is somewhere between 2.5 and 2.7. For example, if you make $100,000/year you can afford a home that costs between $250,000 and $270,000. Or if you live in an area where the median income is $100,000 you can expect the median home in your area to cost in that same price range. Another way of thinking about it is 3 times your gross income minus your debts.

The national ratio has remained constant for the past 30 years indicating that generally speaking housing prices have successfully fluctuated over time and with the economy. However, a recent article by Forbes in conjunction with Zillow, predicts a problematic trend. According to the article, historically low mortgage rates (which are translating into big savings for homeowners) are masking a change in the price to income ratio. Essentially, the position is that while home prices have been increasing for the past year or so median wages have not. This means that price to income ratios are on the rise. This results in potentially a large problem in that once mortgages rates rise, the market will be left with an excess of homes that are too expensive to afford for the average individual. Stan Humphries, Zillow Chief Economist, explains it by stating "Current affordability is almost entirely dependent on low interest rates, and there's no doubt that rates will begin to rise in the next few years. This will have an undeniable effect on demand for housing, as home buyers will have to spend more of their incomes to buy a home. Home values will have to either remain stagnant while incomes catch up or, quite possibly, home values will have to fall in some markets" (Forbes). Continue on to the Forbes article to learn more as well as to see a chart that compares the price to income ratios of the U.S.'s 30 largest metro areas. 

2. Affordability Index - This index sometimes called the debt or front-end income ratio is concerned with the percentage of monthly income that goes towards mortgage payments. For example, if you made roughly $8300/month or $100,000 a year and you had a mortgage payment of $1045 you would spend approximately 12.6 percent of your monthly income on your mortgage (the national average at the end of the fourth quarter in 2012). This current average of 12.6 percent is considered a historical low as from 1985 to 1999 homeowners on average spent 19.9 percent of their monthly income on their mortgage payments. In one article I read, they reported that most mortgage lenders recommend that a mortgage payment not exceed 28% of a person's gross monthly income. This can be calculated by multiplying an annual salary by 0.28 and dividing by 12 months. So if you made $100,000 and spent 28% of your income on a mortgage payment you could expect to pay $2300/month. By this calculation/percentage indicator someone can "afford" a much more expensive house or take on a shorter loan. This begins to reveal how difficult it is to really understand how much house you can afford. 

3.  Total Debt-to-Income Ratio - This ratio also know as the back-end ratio looks at what percentage of your income goes toward all debt obligation. This includes your mortgage, credit cards, student loans, car payment etc. In an article by SFGate, it is stated that this percentage should not exceed 36 percent of your gross monthly income. So using the same salary of $100,000 multiplying it by .36 and dividing it by 12 months this person's total debt payment should not exceed $3000 a month. While this ratio is not discussed as often, I think it is particularly important to current and future home-buyers as most people today are paying off some sort of student debt. 

Ultimately, it will be your lender who determines how much you can afford. However, if you leave it just up to them and don't do your research and consider all the factors you might end up spending quite a bit more than you reasonable should be. That is why it is so important to educate yourself so that you can be a responsible home-buyer!

a quick history...the mortgage crisis

As a continuation of the first time homebuyers series, I thought I would do a quick history of the mortgage crisis - haha just kidding. But what I do want to do is direct you all to the two part series entitled The Giant Pool of Money and Return to the Giant Pool of Money created by the radio show This American Life. For those of you who don't already listen to This American Life, it is a weekly public radio show broadcast that has a theme to each episode and presents a variety of stories on that theme. 

The Giant Pool of Money episode first aired in May of 2008 and presents an amazingly thorough and easy to understand explanation of the housing crisis. The second episode in this series aired in September of 2009 and does an equally great job of following up with the original stories. While it has been almost six years since the stock market crash and five years since the first episode aired, the stories are still very relevant as they provide a context to the post mortgage crisis environment that first time homebuyers are operating within. And again, I am not an expert so I will not go into detail about what characterizes the post mortgage crisis environment but I think we all can agree that times have changed. 

When I think about buying now (which in all fairness I didn't think much about buying a home prior to 2008 as I was 20 years old) I feel an immense amount of fear. Fear of taking on a mortgage that is too big for us, fear that we won't be able to sell the house when we are ready, fear that we will have to take a loss when we sell and the list goes on. I know that when we do decide to purchase we will try to be educated as possible and hopefully will be able to reduce (but not eliminate) some of this fear but buying a home seems to be a pretty scary thing these days.  I try to balance the feelings of apprehension with thinking about all the positives of owning your own home and there are a lot. So my recent homeowners/lookers, how do you feel about it? Would love to hear your thoughts!

First time homebuyers

We have several friends who have recently purchased their first home or are in the process of looking. Most of them have been working for a few years, are feeling settled (enough) to stay in one place for a while and were tired of renting. I have spoken with all of them about what their experience has been like as first time homebuyers and they have all said the process is rather overwhelming. They didn't know where to begin, what they should be committing to, who the appropriate people were to talk to, if they were getting a good deal etc. Hearing all of this and knowing that at some point (not sure when) we would be in the same position, I wanted to do a first time homebuyer series. However, I was/am unsure where to start as its not necessarily a linear process and seems very dependent on location and timing. So I decided that I would just come at it from all different angles without necessarily having a plan. 

I will start with sharing an article I read in USA today a couple of weeks ago. Entitled First time buyers losing out as home sales rise, the piece describes how for the last 14 months U.S. home prices have risen showing a positive trend in the market, however, the number of first-time buyers is lower than in years past. According to the National Association of Realtors, in May of 2013 first time homebuyers accounted for 28% of existing home purchases which is down 6% from last year and 8% from two years ago. The article, written by Julie Schmit, goes on to cite three key factors in this reduction.

1. Competition - A growing number of current buyers are cash buyers (33% this past May) or repeat buyers who can provide larger down payments. First-time buyers are unlikely cash buyers and often use low down-payment loans for making their first large purchase.

2. Tight Credit - Home loans are harder to get since the mortgage crisis especially for those with a lower credit score.

3. Recession - The recession affected everyone, however, the 25-34 year old age group experienced a higher unemployment rate than adults overall according to Jed Kolko, a Trulia economist.  

The implications are that young people are missing out on low interest rates and below average home prices. In addition, first time buyers are vital to a housing recovery as they allow existing home-owners to sell and move into larger and more expensive homes. 

As I am not economist or anyone who really knows anything about mortgages and the housing market, I can't really personally comment on the article. It did get me thinking though and has sparked me to pay closer attention to what is going on with mortgage rates and current market trends. 

Stay tuned...