People that are looking to purchase a home frequently question how much they can afford to pay for a house. Although numerous financial experts claim to have a simple formula for the answer, the truth is there are several factors to consider. Affordability of just the purchase cost, down payment, and monthly mortgage price shouldn’t be the only components to consider when trying to calculate the affordability of purchasing a house. Buying a home has always been part of the American dream. However, it is important to carefully consider what a buyer can realistically afford so a home purchase does not become an unaffordable nightmare.
What do many financial experts claim is acceptable to spend on buying a house?
A popular general rule for buying a house is generally not to spend more than 30% of your monthly income. Even though some of the financial professionals that use a set percentage do include other expenses when coming up with the acceptable 30% of income to buy a home, many do not. They just simply state not to spend more than that amount when buying a house.
The problem with just stating not to spend more than 30% of a person’s income to purchase a home, is this doesn’t factor in other expenses, such as credit card and student loan debt. Using a debt-to-income ratio is really a much better method for starting to understand what a person can afford when buying a home. This considers all the money a person owes in debt compared to their income. The reason this is a more comprehensive method for figuring out home affordability is that the debt a person has will still need to be paid off even after acquiring a home. For example, if a home buyer has $40,000 in student loans, this is not just going to go away when this person buys a house.
There are two common debt-to-income ratios that can be calculated when buying a home. The front-end DTI is determined by adding up monthly housing expenses and dividing it by gross monthly income, then multiplying the result by 100. For example, if all a person’s housing expenses total $2000 and the gross monthly income is $6,200, the DTI is 32 percent.
To determine the back-end debt-to-income ratio, add up all monthly debt payments, including housing expenses, and divide this by the monthly gross income. For example, a potential home buyer with an auto loan that is $500 per month, has a student loan payment of $300 per month and another $300 per month toward credit card bills amounts to $1,100 each month in debt. Combine this amount with the $2,000 in monthly housing expenses and this is $3,100 in total monthly debts. Based on a monthly income of $6,200, the back-end DTI ratio would be 50%.
Using a debt-to-income figure instead of just a flat percentage of gross income to calculate home affordability is a much better method. The reason for this is the calculation is much more realistic for finding what a person might actually be able to afford when buying a home. Furthermore, banks will regularly look for debt-to-income numbers for a home mortgage applicant. According to Bankrate.com, lenders commonly look for the ideal front-end debt to income to be no more than 28 percent, and the back-end DTI, including all monthly debts, to be no higher than 36 percent.
The mortgage you qualify for and the amount of money you spend should likely be very different.
A home buyer should have a good understanding of their debt to income as a good starting point for deciding what they can afford for buying a house. The financial institution that will lend them money for a mortgage is also going to look closely at a potential customer’s debt and income. This isn’t the only consideration a lender may have. A person’s savings, investments, and numerous additional financial factors can also play a role in getting a home loan.
When it comes to home affordability it is important to be aware that the amount of money a bank might lend a potential buyer could possibly be more than a person should probably borrow. Just because a mortgage lender approves someone for a 500k loan doesn’t mean that person should spend that amount to purchase a home. It is almost always better to buy less than a person could probably afford.
Mortgage lenders many times push the limits on what they probably should allow a person to borrow for a home purchase. Just because they are comfortable with a particular dollar amount to lend for a home purchase does not mean the buyer can realistically afford it.
Don’t let the real estate agent dictate what you should purchase or can afford.
When purchasing a home most people will go through a real estate agent. Almost all of them work off some type of incentive plan. This means it is in their best interest to sell higher-priced homes and as many of them as possible. There is nothing wrong with this but it is important for homebuyers to understand real estate agents are looking out for their interests first and foremost.
If a home buyer tells a real estate agent the amount of money, they have qualified for to purchase a house, it should not come as a surprise when the agent tries to show the potential buyer homes at the top of their financial range. Once again, just because a bank approves someone for a certain dollar amount on a home purchase this doesn’t mean that buyer should spend that exact amount.
What does the average home buyer look like?
According to Rocket Mortgage, the average home buyer has a credit score of 758 and a median salary of $72,615. The median home purchase price is $460,000 with an average loan amount of $291,000. The typical mortgage payment is around $1,600.
Married couples make up 62% of home buyers while single females are 18% and Single males 9%. The overwhelming majority of home buyers being married couples should not come as a surprise because this often results in a household income of two people.
Affordability to purchase a home is becoming a big problem.
Although the general standards being reported for purchasing a home appear reasonable, this isn’t necessarily the case. Using the median income of a home buyer at $72,615 and an assumption not to spend more than 30% of monthly income on a mortgage, this turns out to have $1,815 to spend on a mortgage before tax. With a typical mortgage payment of $1,600, this does not leave much money left for insurance and taxes assuming the average mortgage is not including these. A single person with the average home buyer income would really have a challenging time with a mortgage if financial hardship was to occur.
What the deeper problem is when it comes to home affordability is many of the statistics do not include the down payment that was required to arrive at the average figures. The median monthly mortgage payment is $1,600 but the average loan amount on a typical purchase price of $460,000 is $291,000. This leaves $169,000 that was paid for upfront on average. Coming up with 20%-30% in a down payment for a home purchase is where the real problem is particularly for young first-time home buyers.
The truth is the true middle-class is currently being phased out from the affordability to purchase a home without some type of generational wealth being passed to come up with the money for the initial high dollar down payment to purchase a home.
Final Word
Although many financial experts would argue that only 30% of a person’s monthly income should be spent on a mortgage to purchase a home, this isn’t always the case. There are numerous factors a home buyer should consider on what they can afford. A home buyer’s debt, the taxes, insurance, and maintenance of a home should also be realistically factored into what it will cost.
Just because the bank approves a person for a certain amount of money to purchase a home and a real estate agent shows homes in that dollar range it doesn’t mean a potential home buyer should spend at the top of what they can actually afford.
When buying a home, it is always better to buy less than you might be able to afford. There are no guarantees in life. With a 15-year or 30-year mortgage, life can change quickly. Plan not for what you can afford today but what you could realistically afford far into the future.
