February 18, 2016
How much house can I afford right now?
To determine how much home you can afford, the basic rule of thumb is to multiply your annual income by 2.5. In 2015, the typical homebuyer followed this guideline, with an annual income of $86,100 and a median purchase price of $220,000.
First-time homebuyers are usually pushed to extend their budget, however. Borrowers who earn just $40,563 would qualify to purchase the average starter home of $189,300, according to the NAR. That’s 4.67 times their annual income. “You’ll earn more in the future,” a broker might say, or, “It’s cheaper than renting.” But their motivation for upselling you may be based on their own desire for a larger commission.
“If it’s a good broker, they’re not driven by the commission necessarily, they’re driven by doing a good job for that client. A good broker is not pushing the client out of their budget,” says Jean Chou, managing attorney of JLC & Associates, a boutique law practice specializing in real estate and business law.
What other debts and obligations do I have?
Another important factor in determining how much home you can afford is something called the debt-to-income (DTI) ratio. This is the total of your monthly debt payments, including student loans, car loans, credit card debt and a potential mortgage, divided by your monthly pretax income.
Banks will allow a borrower to have a DTI of 43 percent, or sometimes even higher, but in practice a DTI that high can leave you living paycheck-to-paycheck in perpetuity. A more manageable DTI is 30 percent or less, the lower the better. That allows room in the budget for retirement savings as well as the occasional vacation splurge without pushing you further into debt.
Prepurchase counseling can help determine if now is the right time for homeownership or if other priorities should comes first. “Many of our families these days have a huge amount of student loans. They may either plan savings or to pay down student debt so that whenever they decide to purchase they are more successful in that endeavor,” says Quercia.
What are my other financial goals?
The risk of overspending increases with a low-down-payment mortgage, which can negatively affect your other financial goals. Let’s say you’re 31 and earn $69,400 a year, the typical description of a first-time homebuyer in 2015. You’ve set your budget at $170,000 and saved up enough for a 10 percent down payment.
Now, with the option to put down only 3 percent, the bank will allow you to expand your budget to $400,000. But stretching your budget comes at a significant, and unadvertised, cost. Buying a $400,000 home instead of a $170,000 home means spending an extra $13,464 on mortgage payments each year.
Sticking to your original budget would allow you to have more equity in your home, and pay less in interest over time. But there’s an even more compelling reason. The cheaper home would allow you to invest $13,464 in your 401(k) each year, and after 30 years you’d have a retirement account worth $1 million to show for it. If you bought the $400,000 home, you’d just have the house. “It’s a matter of financial responsibility and making sure that they’re not stretching themselves,” says Chou.
How long do I plan to stay in the home?
The cost of homeownership can be less than the cost of renting, but it largely depends on how long you stay in the home. According to research from the University of North Carolina at Chapel Hill, between 2003 and 2011, low-income homeowners who took advantage of a 3 percent down-payment mortgage spent $27,000 less than low-income renters.
“For someone who is looking to change residence one or two years from now, it may not make sense,” says Dr. Lawrence Yun, chief economist and senior vice president of research at the National Association of Realtors. “But for someone who believes they will be staying in the same residence for seven years or more, certainly If they have the financial capacity homeownership would make sense.” Anything in between is a matter of personal choice.
How stable is my current job and what is my future employment outlook?
“The homeownership rate among the younger generation is at historic lows and certainly reflects the economic anxiety, job security or sluggish wage growth. All that has prevented that conversion from renting into ownership,” says Yun.
Waiting to buy until your job is relatively stable is a wise move. A mortgage is a contract, and the payment is due each month regardless of whether you received a paycheck. Having an emergency fund with six months or more of living expenses is a good backup plan, just in case you do experience temporary unemployment or hardship.
If keeping up with the mortgage payment becomes challenging, the first thing to do is contact your bank. “All the big lenders should be open to working out some sort of modification with you. Generally there are ways where you can try to negotiate a payment plan,” says Chou.
Thinking long and hard before any home purchase is important, but with the availability of low-down-payment mortgages it’s even more essential. For many families, buying a home may provide the path to financial security, but for others it could just as easily undermine it.
“The important lesson of this is, if families realize it’s not for me, it doesn’t mean it’s not for me ever. It’s just not for me now,” says Quercia. “When families are ready, it’s a positive thing.”