Many wannabe house
purchasers wonder whether or not they can afford the price quoted on
the house they would like to buy. Or if they have not started their
house shopping, they may be wondering what price range they should
be exploring.
If you intend to buy
with all cash, you can pretty much answer the affordability question
on your own. But if you will need a mortgage, as most home buyers
do, the decision is no longer yours alone. A lender is also
involved, and behind the lender are multiple government agencies
that set rules that the lenders are obliged to follow. These rules
define the minimum documentable income and cash borrowers must
have, and the maximum debt payments they are allowed to have. In
addition, when the purchaserâ€™s down payment is less than 20% of the
price, mortgage insurance is required at premiums set by private
insurers or by FHA.
To qualify for the
mortgage required to execute a purchase, affordability must be
calculated three times using three different rules. These are the
"income rule", the "debt rule", and the "cash rule." The final
affordability figure is the lowest of the three.
The Income Rule:
The income rule says that the borrower's monthly housing expense
(MHE), 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%,
for example, and John Smith's income is $4000, MHE cannot exceed
$1120. If property taxes and insurance are $261 and mortgage
insurance is $103, the maximum mortgage payment is $756. At 4% and
30 years, this payment will support a loan of $158,353. Assuming a
5% down payment, this implies a sale price of $166, 687. This is the
maximum sale price for Smith using the income rule.
Note that the income
used to qualify wouldbe purchasers today is not the income they
believe they have but the income that they can document. The
documentation rules today are much stricter than they were before
the financial crisis.
The Debt 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 41%, for example, the THE for Smith
cannot exceed $1640. If taxes, property insurance and mortgage
insurance are $364, existing debt service of $240 raises the total
to $604, reducing the maximum mortgage payment to $1032. At 4% and
30 years, this payment will support a loan of $216,164. Assuming a
5% down payment, this implies a sale price of $227,541. This is the
maximum sale price for Smith using the debt rule.
The Required Cash Rule:
This rule says that the borrower must have cash sufficient to meet
the down payment requirement plus other settlement costs. If Smith
has $20,000 but must allocate $3,000 of that to points and $6,000 to
other closing costs, the $11,000 left for down payment at 5% will
support a price of $220,000. That is the maximum sale price using
the cash rule.
Since the maximum sale
price of $166,687 under the income rule is the lowest of the three
affordability measures, 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 an OnLine
Calculator to Measure Affordability:
Online calculators that measure affordability use two approaches.
One approach was used above to explain the three affordability
rules. It begins with a potential purchaser whose finances are
known, and calculates the maximum price under each of the three
rules. The lowest of the three is the affordability estimate.
The second approach begins with an assumed house price that the user wants to check. The calculator then shows:

The minimum cash required for the down payment and closing costs.

The minimum monthly income required for the mortgage payment, taxes, homeowners insurance and mortgage insurance.

The maximum allowable nonmortgage debt payments.
If the user can meet all three of these requirements, the assumed house price is affordable.
My calculator 5a, developed with Chuck Freedenberg, is unique in using both approaches. Users can pick the approach with which they feel most comfortable.