When I recently wrote about whether now was the right time to buy a home, I argued that the price of the home was more important than the interest rate you received. Assuming you maintain good credit, you should have the opportunity to refinance a high interest rate downwards at some point in the future. On the other hand, you can never lower a high purchase price. You paid what you paid and now that’s what you owe.

While you’re better off paying a lower price, no one knows when prices will hit bottom until after they have started rising again. By then, it’s too late. Trying to buy a home at the exact right time is no different that trying to time the stock market. It’s a losing bet.

Therefore, nothing’s really changed for a potential homebuyer. The considerations are no different in this kind of market than those questions you’d ask in a booming real estate market. But, my, how the answers have changed! Here’s how the housing market traditionally works (and, for the most part, is working now) compared to the recent housing boom:

Key Consideration
Do you plan to live in this neighborhood and this home for at least the next five years?

Boom Guidelines
“You’ll just need to be here three years” was often the minimum bantered about. And that was from the more responsible folks. With housing prices skyrocketing, you actually only needed about seven minutes to make money by selling, but there aren’t too many people feeling that confident today. Just ask someone in the Miami condo market (a buyer or a seller) of his current expectations.

The Way It Is and Ought To Be
Do you have the job security and the job satisfaction to be confident in the five-year minimum? Or have just moved to the area? How well do you know this town? For that matter, how well do you know your employer?

Ideally, you’ll want to possess not only the desire, but also the confidence that you’ll be satisfied and capable of living in any home you purchase for at least five years. Even in a stable housing market, short time frames could mean you lose money on your home after you factor in the transaction costs of buying and selling it. Plus, if you’re only in a home a year or two, the odds that it will be worth less than you paid for it go up dramatically.

Net: Five years means five years.

Key Consideration
Do you have an appropriate downpayment?

Boom Guidelines
Those loose coins in your car and in your couch? That’s plenty! Seriously, “no money down” loans were common. The lenders weren’t concerned that you had no equity in your home because shortly after you left the room (again, about seven minutes), your house was up several thousand dollars and, presto, you had equity.

The Way It Is and Ought To Be
You should be able to put at least 20% down. So folks, if the home you’re looking at costs $250,000, you should have $50,000 of cash ready. You’ll borrow the remaining $200,000. That $50,000 you’re handing over is the equity you have in your home.

Even if you can get a loan from a bank without putting in 20%, you’ll most likely be charged primary mortgage insurance, or PMI. While some insurance is a good idea, this one . . . not so much. You pay the premiums, but the insurance isn’t actually for you. Instead, the insurance is for the lender. In the event you default on your mortgage, the PMI somewhat protects your lender from your difficulties.

Because you’re not putting in 20%, you’re a higher risk to default. Think about PMI as an extra cost that gets you nothing. Sort of like another utility bill except without the electricity bill, you’re using a lot of blankets and Sterno. Without the PMI bill, you’re being financially savvy.

Key Consideration
Can you afford the monthly payment?

Boom Guidelines
If you could answer yes to the question “Do you intend to one day consider going back to work?” the loan was yours! Seriously, you didn’t have to show proof of anything. Such loans are now known as NINJA-loans: No Income, No Job, No Assets.

True. And scary.

The Way It Is and Ought To Be
To determine what you can truly afford, you’ll need two pieces of information and then understand two rules:

Two Pieces of Information
1. What’s your gross income?
2. How much monthly debt do you have?

First Rule:

Your monthly home payments should cost no more than 28% of your grossly monthly income.

Let’s talk about what that means. Remember, despite what it says on the real estate web sites, your monthly home payment is not just your mortgage. Although the mortgage is the biggest part, your monthly housing payment also includes 1/12 of your annual real estate taxes and the monthly cost of homeowner’s insurance.

Second Rule:

Your total monthly debt shouldn’t exceed 36% of your gross income.

For this calculation include not only the housing costs, but also any payments you make each month for your student loans, car payments, credit card balances not paid off entirely, and the amount you owe Vinny because of the outcome of Super Bowl XLII. (How did Tyree catch that ball?)

Here’s an example:

If your gross income is $60,000 per year, your monthly gross income is simply 1/12 of that amount, or $5,000. Multiply your monthly gross income by 28% to calculate the maximum amount you can afford for your housing expenses each month: 0.28 x $4,166 = $1,400. If you have no other debt, you’re done (and also, perhaps, a liar).

However, if you also have a $249 monthly car payment and $200 you owe each month on a student loan, then you have $449 in other monthly loan payments. Since the most you can afford to carry in total debt is 36% of your gross income (0.36 x $5,000) = $1,800 and you must subtract $449 from that total, the most you can borrow under the second rule is $1,351.

Your maximum monthly housing payment is the lesser of the amounts calculated by the two rules. Since $1,351 is lower than the $1,400 figure calculated under the first rule, $1,351 is the most you can afford. Said another way, what you pay each month shouldn’t exceed $1,351. (Of course, it is possible that you might be able to borrow more assuming an even higher monthly payment. Depending on your credit score, it could also be less.)

We’ll get into how your monthly payments translate into an estimate of a house you can afford, but, by traditional standards, those two rules tell you the most you’d ever want to pay each month. Especially if you like the idea of sleeping well in a house you can afford while living Beyond Paycheck to Paycheck.

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One Comment to “How home affordability has changed now that the boom is over”

  1. Thanks for sharing with us this instructive article I`m sure it`s very helpful to anybody considering to buy a house. I`ve discovered many interesting deals what concern the Toronto houses the only problem is I can`t really take a mortgage now and as you`ve said it`s better to have a saved amount by which you can make sure you are able to buy that property. The mortgage plans I think that are not at all consumer-based and the propblem derives mainly from that fact.

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