Friday, July 31, 2009

A Borderline Home Buyer as Benchmark: Can I Afford This House?



Home Affordability "Benchmark"


This post discusses the "Borderline Buyer" column of the Planning to Buy a House Spreadsheet. The previous post covered the Proposed Purchase column. As you might guess, the Borderline Buyer column develops a profile of a borderline buyer for the property you are proposing to purchase.

My borderline buyer is pushing the typical debt load limits. As a result he should not thought of as a benchmark in the sense of being a buyer to be emulated. He is just barely able to afford this house! In my opinion, a buyer's objective should not be to get as close as he possibly can to the lender's limits; the closer he is to these limits, the closer he is to the limits of his ability to manage his debt (and the more he is at risk of ultimately losing his home). Still, this is a great buyer to compare yourself against.

Excel spreadsheet to evaluate/benchmark purchasing a home affordabilityNote: Click on the above screenshot to expand it. The link to download the spreadsheet is at the end of the post.

The Borderline Buyer Column


Above is a portion of the Excel spreadsheet (click to enlarge. The link to download is at the end of this post). The benchmark buyer column represents a hypothetical buyer for the same property that you are planning to buy. The model assumes that buyer:
  • Pays the same price as you
  • Has a 30 year mortgage at the same interest rate as yours
  • Has the same property taxes, insurance and home maintenance expenses as you
  • Has the same one-time costs as you (e.g., closing costs, moving costs) -- except for the down payment.

However, the model assumes that buyer puts 20% down. Given that, the model back-calculates:
  1. The minimum annual income needed to support the monthly housing expenses without exceeding the standard 28% housing debt load limit.
  2. The maximum non-housing debt (i.e., auto, credit card, etc.) that this buyer could carry without exceeding the 36% total debt load limit.


Can I Afford This House? Salary Required (+ The 2-3 Times Salary Rule of Thumb)

The borderline/benchmark buyer is a great buyer to compare yourself against. Under normal circumstances, the benchmark buyer's annual income would be the minimum annual income required. If your income is less than the benchmark income, buying a house at this price is likely to be a stretch unless you can put more than 20% down.

From the example we see that to purchase a $150,000 home with 20% down a buyer would normally need to earn at least $50,093 (assuming the interest rate on 30 year mortgages is 5.5%). In the old days the rule of thumb was that your home should cost no more than twice your annual salary. These calculations suggest that, using current guidelines, you can go up to approximately three times your annual salary. (However, if possible, I still think it's better to try to stay within 2.5 times your salary.)

Some Other Key Buying a Home Benchmarks: Savings and Monthly Housing Expense

The next key number in the borderline buyer column is the "current savings" number. Normally, I would recommend that you accumulate at least this much in savings before you make your purchase. That way you will have enough to cover the down payment and other initial costs such as closing and moving expenses.

The third key number is the planned monthly housing expense. Again, you should plan to budget at least as much as the benchmark buyer for monthly housing for a house in this price range -- unless you are planning to make a substantially larger down payment.

Saving to Buy Your First House

Cranking through the numbers, it follows that for a home valued at three times your salary, a 20% down payment will be equivalent to 60% of your annual salary. Closing costs and other one-time costs could easily bring your total one-time costs to approximately 75% of your annual salary. It follows that, if you only save 10% of your salary per year it will take you approximately (60% / 10% =) 6 years to save the down payment, and could take as long as (75%/10%=) 7.5 years to save enough to cover all of the initial/one-time costs.

In my opinion, the best way to speed up the timetable is to either save 15-20% a year, or buy a house closer to two times your salary. The Proposed Purchase column (discussed in this post) gives you the ability to experiment with different options.

Link to Excel Spreadsheet

Here's the link to download the Planning to Buy a House Calculator to Excel. If you have any problems accessing or using the model, see this post.

Related Posts

The Planning To Buy a House Spreadsheet post discusses the Proposed Purchase column of this same spreadsheet and includes links to additional sites useful for estimating your expenses.
Planning to Buy a House discusses additional strategies for becoming a successful homeowner.
100 Years of Housing Price History: Robert Shiller index of housing prices since 1900, plus discussion of the economics of residential real estate ownership.

The picture is from Public Domain Pictures.
Last updated 6/11/2011

This work is licensed under a Creative Commons Attribution 3.0 unported license.

3 comments:

  1. Thanks a lot for this informative article. Yeah, buying a cheaper house could be the solution for some situations. However, we still have to think about the costs that come with moving. They might cause some trouble too.

    Best regards, Jay.

    ReplyDelete
  2. Jay,
    Agreed. That's part of the point of the "one-time costs" line in the spreadsheet. Buyers need to be sure to estimate their move out, move in & start-up costs. The initial spreadsheet includes a ballpark, reasonably conservative, estimate for these costs -- lumped in with other one-time costs such as closing costs. The idea is to refine this estimate and update the spreadsheet as you get closer to choosing a specific location and property.

    Note: readers may find Jay's post (click on Moving Guide) useful in helping to identify move-related expenses that are sometimes overlooked. However, don't stop there: what about new curtains, a new piece of furniture or two, etc.? I find it helpful to think through my new home room by room.

    I have added some links that I have found useful in estimating these costs at the end of the "Planning To Buy a House Spreadsheet" post.

    ReplyDelete
  3. Hey, thanks a lot for adding the links. Yes, you are absolutely right - thinking through a new home room by room is pretty good and helpful. A great tip.

    Jay

    ReplyDelete

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