Can we afford this $445,000 house? How can you tell?

September 20, 2009 3:16 PM

Can we afford this house in California (just an example)? What "rules of thumb" or other measures should I use to determine what is "affordable"?

I have used many of the on-line "calculators" but I feel like there are too many variables which are not explained and there is too much variation. Can you look at our situation and help suggest how much house we can afford while remaining fairly conservative? What other "rules of thumb" or standard rules should I consider when determining how much house we (or anyone) can afford?

Total income: $120,000/year
House price: $445,000
Loan: FHA with 3.5% down
(the down payment is not set at this amount but it is so common that we use it when making comparisons).

We're fairly frugal and save more than average. We're both local government employees. The house is in Northern California (Bay Area). The house included above is just an example.

Conservative rule of thumb for front end debt-to-income (DTI) ratio -
28% of your pre-tax income = reasonable annual payment (before considering tax benefits):
$33,600/year
or
$2,800/month

Conservative back end DTI ratio:
36% of pre-tax income minus other debt payments.
We have about $600 of debt (student loan) payments/month.
$43,200 - 7,200 = $36,000
or
$3,000/month

I have received several "Good Faith Estimates" (GFE) for a loan in these conditions - the highest GFE (with most fees filled in) places our monthly payments at $2950.

Is that reasonable based on our income? How do you make that decision?

The tax rate for the city at issue is 1% (low) and no flood insurance is required. This is included in the GFE above. We also have a reasonable emergency fund.

Email questions/suggestions/issues to [e-mail]

Thanks mefites!

posted by anonymous to work & money (17 comments total)

You seem to be doing the math right. But remember that your monthly payments are the payment to the mortgage company PLUS the escrow or set aside for taxes and home owners' insurance (also mortgage insurance if your lender insists). You also need to find out average monthly utilities (water, heat, electric, and I'd throw in internet/cable). Conservative spenders like me like monthly total housing cost equal to 25% of take home pay; I believe the rule of thumb is 30% (?) and I know some people are comfortable with 50% but that's not going to leave you with much discretionary spending power.

Not that you asked, but here's what I wish someone had told me when we bought our house-- assume $3,000 to $5,000 per year in maintenance and emergency costs. Because we did not anticipate this we did ZERO maintenance for like 10 years; a neglected house looks like a slum if you don't maintain it for ten years. We're still digging out from under the mountain of stuff we need to do. If you don't spend it, save it, because eventually you're going to need a new roof or a new heating system, or a new bathroom, and that's getting into 5 figures.
posted by nax at 3:23 PM on September 20

Do a monthly budget in which you calculate the cost of every expense, not only mortgage and property tax payments but utilities as nax mentions, and home insurance, and then food, clothing, car payments, car insurance, and gas. Set aside sums for housing renos and maintenance and savings if you can. Firgure out how much spending money you'll have. Look at those numbers and figure out whether you'll be comfortable living with them. You should have a pretty good idea of what kind of budget you can live with already from your years of paying rent, so the idea is to see how much that budget will change and if you can live with those changes.
posted by orange swan at 3:33 PM on September 20

Couple questions to consider:

What's the status of the homeowners association? Believe it or not, the homeowners association and their reserves, actually plays a part in your financing. If their reserve is shot to hell, financing now just got extra complicated and difficult. If there are pending assessments, same deal. Get a copy of all CCRs for the Association. Find out what that $101 a month covers. I'm never buying into a COA or HOA again. And that's from someone who is a Board member.

Is that GFE including insurance on the actual dwelling? Factor into that you'll have to insure your possessions.

If financing is okayed and you're good... you make that decision by looking good and hard at your income after taxes each month versus your expenses and your quality of life and longterm financial and career goals.

What do you have in personal reserves? If the hot water tank/stove/fridge/car dies, is that going to be paid for in cash or financed/charged? If the Association tosses a 5k assessment next year, how does that get paid? And this might just be in our unlucky case, but god dammit, nothing in the house dies alone, it always takes something else with it. About 3 years ago, the stove went, then the central AC went and then my car needed about $600 worth of work. I was out on the deck (which at that point, didn't need work) and yelling, "ENOUGH!" and shaking my fist skyward.

After that 2950 a month, what's leftover? Can you afford all your necessary utilities (water, electricity, heat) and the enjoyable utilities (cable, broadband, monthly subscriptions etc). Groceries? General expenses? Can you manage to save still? Are things going to be tight? If so, for how long? Sit down and write out each and every expense you now have and the additional ones you expect to incur as a homeowner.

And hey, don't get me wrong, we did the meager lifestyle for a bit here too, especially after we bought and the couple years following. We had to and it taught us a lot about our own idiot financial mistakes. Was it fun? Oh hell no. But we overcame and we made lifestyle changes that we still employ to this day.
posted by jerseygirl at 3:41 PM on September 20

I don't see your inclusion of the mortgage interest tax deduction, it's quite significant, over $900 per month, at least for the first 10 years until you've made a dent on the principal.

Using my spreadsheet:

Purchase Price 445000.00
Down Payment 12905.00 (3.50%)
Loan Principal 429425.00

Points 7514.94 (1.75%)
Points Net Tax 4734.41

IO 1968.20 5.50%
PMI 178.93 0.50%
Prop Tax 457.61 1.23%
Tax Credit -963.75 37.00%

Subtotal 1640.98

HO Ins 80.00
HOA/Utils 250.00
Maintenance 100.00
Opportunity 29.40 (2.00% APR on down payment and after-tax points paid)

Total Other 459.40

Nominal Cost 2100.38

Actual Expense 2291.01

"Nominal cost" is all outgo except principal repayment, which with real estate is mostly if not entirely a form of savings and not expense (ie. you'll get it back when you sell).

"Actual Expense" is actual out-of-pocket expenses less the tax benefits you get. This will increase over time as your principal balance goes down.

The PITI with these numbers, btw, is $3154.76 per month. That's the monthly nut that will not change until the loan is paid off.
posted by Palamedes at 3:42 PM on September 20

What "rules of thumb" or other measures should I use to determine what is "affordable"?

The rule of thumb is that your house should be (conservatively) no more than 3 times you annual income, or (more aggressively) no more than 4 times. This puts you right in the middle of that range. Actually a bit towards the high end.

But I think those figures are sort of a simplification of the front end and back end ratios, which you seem to have a handle on directly, so I'm not sure if there are really a whole lot more rules of thumb that you need to learn.

Try figuring in a larger down payment? That will reduce your monthly debt burden, and give you additional padding and thus more options to refinance in the future should it become necessary. I mean, in theory; refinancing is really hard right now but it should be an option again at some point down the road.
posted by rkent at 3:48 PM on September 20

The rule of thumb I have always heard is that your monthly housing cost should be no more than 1/3 your monthly pay. The other rule of thumb is that your monthly payment will be $1,000 for every $100,000 borrowed on a 30-year mortgage (so, a house that is $445,000 will have a monthly payment of about $4,450).

So, for the house in question, you make $10,000/month. One-third of that is $3,333 to apply to a monthly mortgage. The house's 30-year note will be $4,450. So, by those rules of thumb, the answer is no, unless you put more as a down payment and the other housing costs aside from the mortgage (such as homeowners' association dues, insurance, etc) are low. But, I'm pretty conservative.
posted by Houstonian at 4:04 PM on September 20

The house's 30-year note will be $4,450.

If interest rates were 9.5%, yes. Pulling numbers out of a hat doesn't work. Spreadsheets can lie to you (garbage in -> garbage out), but they are the basis of all financial analyses.
posted by Palamedes at 4:18 PM on September 20

That's true; rules of thumb are not as accurate as spreadsheets. She asked for rules of thumb for determining affordability, though. I will say it worked for me: I borrowed about $100,000, and my monthly payment is about $1,000. And my interest rate is just a tad more than half the 9.5% you mention. So, my rules of thumb worked for me... and maybe are helpful to the poster.
posted by Houstonian at 4:27 PM on September 20

Prop 13 means Texas is apples to California's oranges.

The payment over 30 years on the $445k house @ 5% is $2300, so you're off by a factor of two off the bat, though total PITI is ~$3000.

With a $100,000 property, PITI is $750 in California. Closer to your rule of thumb, but the numbers don't scale linearly. Also $100,000 will buy you precisely nothing in the Bay Area so going from your particular baseline is not going to be helpful given these differences in tax regimes and area values.
posted by Palamedes at 5:28 PM on September 20

Property tax is deductible except under AMT. Only god (and possibly your accountant) know if that'll affect you, but don't count on deducting it.
posted by jewzilla at 6:02 PM on September 20

This article might help
posted by bananafish at 6:07 PM on September 20

This article might help (fixed link)

FWIW, the best rule of thumb is being able to at least survive on one income (the lesser, at that) for a couple of years. If banks only approved loans based on one income in the household it would certainly keep prices down, but they stopped doing that in the 1970s.

Paying 20% down is neither here nor there in my book. I'd prefer having the 16.5% socked away and make accelerated payments towards the mortgage. I've heard of a loan product that actually let you get ahead and later "coast" if you need to, but I can't recall if this was a fixed or balloon loan.
posted by Palamedes at 6:35 PM on September 20

Also to the point is whether anyone should be paying 445k for a house in that area that sold for 450k almost a year ago. On the page you linked for the house, there's also a little graphic showing the trend for the market value of houses in the zip code -- certainly current values are not where they were a year ago.

445k on 120k sounds, to me, like a bad idea. PITI is the minimum you're going to be spending on the house every month, exclusive of maintenance, assessments by the homeowners' association, furnishings, etc. I'd say you'd be house-poor after spending that much, and should look in the 350k range instead.
posted by palliser at 7:13 PM on September 20 [1 favorite has favorites]

Seconding the NYT article that Palamedes linked to above. That got passed around a LOT last week.
posted by intermod at 7:42 PM on September 20

I emailed the OP and he asked me to include the following additional information: the house she is actually considering does NOT have any HOA fees.

(I'd look at the irvinehousingblog for theory relating to house price trends, I related as much to the OP.)
posted by No New Diamonds Please at 12:04 PM on September 21

PITI is the minimum you're going to be spending on the house every month

With the mortgage interest deduction, not really. The upper middle class is in the 37% bracket in California, so this is significant. I made this mistake in 2000-2001, not buying a very nice condo for $350K since my spreadsheet was telling me that renting was still OK. (Plus I was counting principal payments in this comparison; I was stupid).
posted by Palamedes at 5:11 PM on September 21

The NYTimes rent vs. buy calculator might be helpful (and it takes into account the tax benefit mentioned by Palamedes @ 5:11).

Be sure to adjust for your estimates on housing value appreciation ... the default is 1% which is rather low.

There's a post about it on Get Rich Slowly with some good tips.
posted by unclezeb at 10:13 PM on September 21