I often see advice on this sub that homebuyers should never spend more than three times their annual income on a house (or alternatively, on the mortgage loan amount). It’s good to be conservative and not end up house-poor with constant cash flow issues, but I wanted to show – through math! – that this guideline depends heavily on interest rates. Most people can’t pay cash for their houses, so interest rates are a valid concern for affordability and shouldn’t be ignored in sweeping “rules-of-thumb."
There’s an older and moderately conservative, but still well-accepted guideline that your total housing payment (principal, interest, taxes, and insurance or “PITI”) shouldn’t exceed 28% of your gross monthly income. In my view, this is a good rule to try and follow whenever possible, even if going a few percentage points over probably won’t spell catastrophe.
I want to show the kind of interest rates that are implied by the blanket “maximum 3x salary” guideline I often see in comments, and you’ll see why I don’t think this rule always makes sense.
Take someone making $48,000 a year, or $4,000 monthly. The 28% rule for a housing payment would cap this homebuyer at $1,120 a month, or 0.28 times $4,000.
Now, let’s apply the “maximum 3x salary” rule-of-thumb, which puts this person’s maximum budget for a house at $144,000. I’m going to assume 1.1% of the house value annually for taxes and 0.25% annually for insurance, so 1.35% total. So we’ll estimate monthly taxes and insurance at (0.0135 * $144,000) / 12, or $162/month. Subtracting this from the $1,120 maximum housing payment leaves $958 available for monthly principal and interest (P&I) payments.
I’m using the Excel RATE function to back into an implied interest rate under a few different scenarios, all assuming a maximum $958 P&I payment (and ignoring monthly PMI, if any, for simplicity):
For a 30-year loan:
- 20% down payment (Loan amount $115,200): Implied rate 9.373%
- 10% down payment (Loan amount $129,600): Implied rate 8.078%
- 5% down payment (Loan amount $115,200): Implied rate 7.516%
- 0% down payment (Loan amount $144,000): Implied rate 7.000%
Yikes! Those are some pretty ****ty rates we’re assuming! Let’s try a 15-year loan instead:
- 20% down payment (Loan amount $115,200): Implied rate 5.772%
- 10% down payment (Loan amount $129,600): Implied rate 3.990%
- 5% down payment (Loan amount $115,200): Implied rate 3.201%
- 0% down payment (Loan amount $144,000): Implied rate 2.468%
These implied rates are much more reasonable, but they still assume a 15-year loan which, rightly or wrongly, simply isn’t feasible for many buyers given that house prices are increasing much faster than incomes in general.
Now, if you can afford a 15-year mortgage and want to be especially cautious with your home-buying decision (this is probably a good thing when feasible), then by all means do it. However, if you’re opting for a 30-year loan, realize this “3x income MAX” metric carries an assumption of interest rates that simply don’t make sense in the current environment. Put another way, this guideline would have made perfect sense in the early 1990s, when 30-year rates actually were in the 8% range, but may well be needlessly conservative in the present.
I know I’m going to get responses that say 28% of gross income is still too risky and a safer guideline is, say, 25% of take-home pay. Again, this is fine if you can manage it! What you end up doing for a mortgage, or even whether you buy at all, is still a personal decision that depends on both your risk tolerance and the stability of your income.
tl;dr – If you’re looking to buy a house, do the math on what you can realistically afford and the risks you’re willing to take. And try not to assume interest rates from 1992 ;)
edit: formatting
Submitted December 19, 2019 at 08:06PM by searediPodReduction https://ift.tt/35FUNUN
