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.

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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.

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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.

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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.