Historically, the median U.S. home price has been around 2.6 times the median U.S. annual income. A similar number – two-and-a-half – is the benchmark that the past few generations of homebuyers have used to measure affordability.
If you earn $100,000 per year, you can likely afford a home with a price tag around $250,000, give or take a few thousand dollars. This calculation assumes a 20 percent down payment and a 25 percent ratio of principle and interest to income.
How Much House Can You Afford?
Some real estate industry professionals argue that many homebuyers can afford an even higher price tag. Qualifying for the loan really depends on your debt-to-income ratio rather than on a comparison between your income and the purchase price. Each lender sets its own guidelines, but in general, starting in 2014, to qualify for a traditional mortgage your total debt payments must not exceed 43 percent of your income before taxes (some lenders will allow debt as high as 48 percent).
Total debt includes credit cards, student loans, auto loans, and any other outstanding debt that has a fixed monthly payment, including the home you want to buy. Furthermore, the house payment cannot exceed 30 percent of your pre-tax pay (28 to 31 percent, depending on the lender); this figure includes property taxes, homeowners insurance, homeowners association dues, mortgage insurance and any other fixed monthly expenses related to the home. So it’s true that buyers with low or no debt might qualify for a loan on a home with a price tag much higher than 2.6 times income.
$100,000 Income: $543,750 House?
Let’s look at a typical example. If a couple has a combined gross income of $100,000, their monthly income before taxes is about $8,333. Their total debt, therefore, cannot exceed $3,583 per month. The total house payment, including insurance, dues, etc. can be no more than $2,500, which is enough to cover the payment on a $435,000 loan (at 4.45 percent interest), plus $200 per month for property taxes and $100 per month for homeowners insurance.
Assuming a 20 percent down payment, the purchase price is $543,750. Great! That’s much better than the benchmark affordability point of $250,000-$260,000. Isn’t it? The answer depends on the couple’s other financial obligations. To max out the house payment at $2,500, the sum of all of their other debt (car payment, student loans, credit cards and any other loans) cannot exceed $1,083.
So if we take their monthly income of $8,333 and subtract $2,333 for taxes (based on a 28 percent tax bracket), $667 for savings (8 percent), $2,500 for the house payment and $1083 for other debt payments, this couple is left with just $1,750 for everything else: state taxes, food, utilities, entertainment, life insurance, auto insurance, health insurance, doctor visit copays, prescriptions, childcare, gym memberships, gas and/or public transportation, travel, hobbies, haircuts, clothing, shoes, cell phone, internet service, utilities and every other household expense, the $435,000 loan begins to look very unrealistic, even impossible.
$100,000 Income: $260,000 House?
If, however, this couple uses the affordability rule, rather than the debt ratio rule, as their benchmark and looks at homes priced at no more than $260,000, they will end up with a payment of $1,050 on a $208,000 loan (after making a 20 percent down payment), leaving ample funds for insurance, taxes and all of the usual necessities.
The bottom line is that as the borrower, you are the best guardian of your money, and you must determine what you can truly afford, notwithstanding the results of any debt ratio calculation. Many real estate professionals earn a commission equal to a percentage of the final transaction amount, so it is in their best interest to get you into a higher-priced home, all other factors being equal.
That’s not to say they are by nature unscrupulous or that the default behavior is to push you into a home you can’t afford. Many agents and brokers are, indeed, very considerate professionals who will show genuine concern for your ability to keep your financial head above water. But at the end of the day, the real estate professional cannot tell you what you can afford. And what’s truly in your best interest is to take on a payment that is well within your means.