Courtesy of The Mortgage Professor, July 13, 2013
The house purchase season is now in full swing, and many wannabe purchasers are wondering whether or not they can afford the price quoted on the house they would like to buy. Alternatively, they may not have started their house shopping and may be wondering what price range they should be exploring. Chuck Freedenberg and I recently upgraded our affordability calculator so that it answers either or both of those questions. It is calculator 5a.
The availability of mortgage financing is obviously a critical feature of the affordability equation, and it is quite different today than when I addressed the issue before the financial crisis. Interest rates are lower for borrowers with good credentials, which may increase the amounts they can afford to pay. However, rates are not necessarily lower for borrowers with less-than-stellar credentials, and more borrowers today are unable to qualify at all. In particular, the income used to qualify would-be purchasers today is not the income they believe they have but the income that they can document, which could me much lower.
Measuring Affordability: The Three Rules
To qualify for the mortgage required to execute a purchase, affordability must be calculated three times using three different rules. I call these the “income rule”, the “debt rule”, and the “cash rule.” The final figure is the lowest of the three. When affordability is measured on the back of an envelope, which real estate brokers often do, usually it is based on the income rule alone, ignoring the other two. This can result in error.
The income rule says that the borrower’s monthly housing expense (MHE), which is the sum of the mortgage payment, property taxes and home-owner insurance premium, cannot exceed a percentage of the borrower’s income specified by the lender. If this maximum is 28%, for example, and John Smith’s documentable income is $4000, MHE cannot exceed $1120. If taxes and insurance are $200, the maximum mortgage payment is $920. At 4.5% and 30 years, this payment will support a loan of $181,572. Assuming a 5% down payment, this implies a sale price of $191, 128. This is the maximum sale price for Smith using the income rule.
The debt rule says that the borrower’s total housing expense (THE), which is the sum of the MHE plus monthly payments on existing debt, cannot exceed a percentage of the borrower’s income specified by the lender. If this maximum is 36%, for example, the THE for Smith cannot exceed $1440. If taxes and insurance are $200 while existing debt service is $240, the maximum mortgage payment is $1000. At 4.5% and 30 years, this payment will support a loan of $197,361. Assuming a 5% down payment, this implies a sale price of $207,749. This is the maximum sale price for Smith using the debt rule.
The required cash rule says that the borrower must have cash sufficient to meet the down payment requirement plus other settlement costs. If Smith has $15,000 and the sum of the down payment requirement and other settlement costs are 10% of sale price, then the maximum sale price using the cash rule is $150,000. Since this is the lowest of the three maximums, it is the affordability estimate for Smith.
Removing Constraints on Affordability
When the income rule sets the limit on the maximum sale price, the borrower is said to be income constrained. Affordability of an income constrained borrower can be raised by an increase in the maximum MHE ratio, or access to additional income — sending a spouse out to work, for example.
When the debt rule sets the limit on the maximum sale price, the borrower is said to be debt constrained. The affordability of a debt constrained borrower (but not that of a cash constrained or income constrained borrower) can be increased by repaying debt.
When the cash rule sets the limit on the maximum sale price, the borrower is said to be cash constrained. Affordability of a cash constrained borrower can be raised by a reduction in the down payment requirement, a reduction in settlement costs, or access to an additional source of down payment — a parent, for example.
Using Affordability Calculators
There are many affordability calculators available on the internet, but to my knowledge, ours is the only one that allows the user to do it two ways. They can specify the house price, and the calculator will return the minimum income, minimum cash and maximum debt to buy that house. Or they can specify their income, debt payments and loan and property features, and the calculator will return the price they can afford to pay.