The Mortgage Professor: Can you Afford that House?
By Jack Guttentag
(MCT)--The house purchase season is now in full swing, and many would-be 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.
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. But 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 can be much lower.
Mortgage 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 affordability 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, which is the sum of the mortgage payment, property taxes and homeowner insurance premium, cannot exceed a percentage of the borrower’s income specified by the lender. If this maximum is 28 percent, for example, and John Smith’s documentable income is $4,000, monthly housing expense cannot exceed $1,120. If taxes and insurance are $200, the maximum mortgage payment is $920. At 4.5 percent and 30 years, this payment will support a loan of $181,572. Assuming a 5 percent 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, which is the sum of the monthly housing expense plus monthly payments on existing debt, cannot exceed a percentage of the borrower’s income specified by the lender. If this maximum is 36 percent, for example, the total housing expense for Smith cannot exceed $1,440. If taxes and insurance are $200 while existing debt service is $240, the maximum mortgage payment is $1,000. At 4.5 percent and 30 years, this payment will support a loan of $197,361. Assuming a 5 percent 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 percent 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.
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 monthly housing expense, or by access to additional income — by 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 cash — a parent, for example.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
©2013 Jack Guttentag
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