Real Estate NewsHelping Clients Estimate Their Affordability Range
Traditionally, real estate and mortgage professionals have encouraged homeowners to stretch – to shop for homes at the upper end of their affordability range. We wanted them to maximize their investment, and we were seeing property values and incomes rise, especially for homeowners who were first starting out. It all made for a very sound investment in housing.
Recently, I have begun to question what an "affordable house payment" means. Even some of the major players in the mortgage lending industry have different ideas of what "affordable" means:
U.S. Treasury: 31 percent front-end DTI (debt-to-income) ratio, and less than 55 percent back-end DTI
FHA (Federal Housing Administration) Old: 29 percent front-end DTI, and 41 percent back-end DTI
FHA New: 31 percent front-end DTI, and 43 percent back-end DTI
Fannie Mae: 36 percent benchmark back-end DTI with a maximum of 45 percent with "strong compensating factors"
Conventional loans: 28 percent front-end ratio, and a 36 percent back-end ratio My rule of thumb is a maximum 30 percent front-end DTI. This means that a homeowner"s monthly house payment or PITIA (principal, interest, taxes, insurance, and association fees) should be no higher than 30 percent of the gross monthly household income. For every $1,000 per month in household income, the homeowner should be able to afford $300 of house payment.
The trouble with these guidelines, even my guideline, is that they fail to take into account other mitigating factors. For example, couple with four children paying their own medical insurance premiums is probably going to be able to afford less house than a young couple with no children whose employers provide health insurance.
Likewise, a family that spends $400 per month to heat their home will have less money available for a house payment. Let"s look at a specific example. Suppose a family of four is pulling in about $6,000 per month. That"s $72,000 annually. To simplify, we"ll assume the family is debt free, except for the new home they are about to purchase. Based on a front-end DTI of 31 percent, the couple should be able to afford a monthly house payment of $1,860. That leaves them with $4,140 per month to cover everything else.
According to Ginnie Mae"s How Much Home Can You Afford? calculator, an annual gross household income of $72,000 can afford a monthly house payment of $2,235. This represents a 37 percent front-end DTI, which is outside most guidelines.
Before we encourage the couple to purchase a $200,000 plus house, let"s take a look at their current monthly budget. Assuming we were to sell them a house and saddle them with a $1,860 monthly mortgage payment, here"s where the rest of the money ($4,140) would be going each month:
Income taxes (28 percent) $1,160
Daughter"s college $1,000
Electricity (avg.) $250
Husband"s health insurance $160
Groceries $400
Auto insurance $180
Auto fuel $100
Auto license $28
Auto maintenance/repairs $200
Charitable contributions $100
Movies, TV, Internet $120
Medical/dental (un-reimbursed) $250
Clothing & shoes $80
Dining out $100
Gifts $50
Personal care $40
Pets $40
Total $4,258.00
Now, you wouldn"t exactly characterize this family as living large, yet if it had a house payment of $1,860, it would be seriously struggling every month to make ends meet.
What we as real estate professionals can learn from this example is that home financing eligibility guidelines are just that – guidelines, ballpark figures to get the conversation going. Mortgage lenders, real estate agents, and other professionals who are providing guidance to homeowners on how much house they can afford do their clients a grave disservice by using these general guidelines to make recommendations to specific families about how much house they can afford.
Currently, we are doing this all backwards. We tell homeowners how much house they can afford and then expect them to make the tough budget decisions to make that payment affordable. When the family still can"t afford their house payment, we assume they are overspending and send them to credit counseling to become further humiliated.
Perhaps a better way to qualify homeowners for mortgage loans is to start with the family"s existing budget and projections and develop a realistically affordable house payment based on current and projected net income and monthly expenses. Remember, every family"s situation is unique. We need to tailor their house payment to their budget, not the other way around.