"Goals are dreams with deadlines" -- Diana Scharf

Wednesday, July 10, 2013

Mortgage Affordability: What the Lenders Tell You vs. What You Should Really Spend

For the past few weekends, Mr. W and I have attended a handful of open houses in our favorite neighborhoods.  Although we’re still a few years away from buying a house, we thought it would be useful to see what types of homes are currently available in our theoretical price range.  We already peruse Realtor.com on a frequent basis, but seeing each home in person gave us a much better sense of the condition of the house, the size of the yard, and the desirability/undesirability of each location.

Before we ventured out to these open houses, we wanted to determine a reasonable price range.  We knew there would be no point in attending open houses for homes that were two or three times higher than our potential budget.  Looking at over-budget homes would simply set us up to be disappointed and discouraged when we finally are ready to buy our first place (this is the same logic I used when I decided not to try on $5,000-$10,000 wedding gowns when planning our wedding.  I didn’t want to get my heart set on something I couldn’t have).  Granted, this was a hypothetical exercise at best.  Over the next few years, our financial situation could change for the better – or for the worse.  It’s impossible to know precisely how much house we’ll be able to comfortably afford in three or four years’ time.  But, we can still do our best to come up with a good estimate.

We had used a few online mortgage affordability calculators, and we were always surprised by the results.  According to these calculators, Mr. W and I could qualify for a mortgage that would result in a payment at least three times higher than our current monthly rent.  Admittedly, we’ve stayed in a low-rent apartment in order to balance out our high commuting costs and to help us save for a down payment.  We could pay a bit more for rent without feeling that we were stretched too thin.  Nonetheless, we can’t imagine having a monthly obligation that is three times what we currently pay. 

In case you haven’t played around with these mortgage calculators, here are a few of the more common guidelines…and the reasons we decided not to use them

Guideline One: Total monthly debt obligations should be no more than 36% of combined gross income.  The housing portion should be between 28% (conservative) to 33% (aggressive). 

Result: According to this calculation, we could afford a monthly payment that is 3-3.5 times our current rent payment.   The loan amount would be almost 4 times our combined gross income.  Despite what the guidelines say, that’s far more than we would be comfortable spending.

Things We Like About This Method: This calculation considers total monthly PITI payment (Principle, Interest, Taxes, and Insurance).  This “big picture” approach is important to us because New Jersey has notoriously high property taxes.  Case in point: On Realtor.com, we recently saw a $425,000 home with annual property taxes of $15,000.   $15,000?!  That’s the same price we paid for Mr. W’s 2 late model Honda.  This was a 2,000 square foot home that sat on .25 acres.  It was a truly lovely home but it was by no means a mansion.  Admittedly, the taxes on this home were a bit higher than average for the size of the house/lot, but we are still anticipate paying $8,000-$10,000 in annual property taxes.    

Things We Don’t Like About This Method: This method does not account for variations in take-home income.  Individuals with the same gross income can have radically different take-home incomes depending on the state income tax rates, health care costs, and retirement withholdings.  Thus, we’re not convinced that using gross income is a good starting point when calculating mortgage affordability.    


Guideline Two: Take out a mortgage that is no more than 2 to 2.5 times your gross annual income. 

Result:  Assuming 4.5% interest rate, 30-year mortgage, a 20% down payment, and the same tax rate as above, we would be paying 1.8 – 2.2 times our current rent. 

Things We Like About This Method: This calculation results in a more conservative estimate than the 28/36 rule. We would probably want to scale back our other monthly expenses, but we wouldn’t feel as cash strapped as if we were to follow the 28/36 rule.    

Things We Don’t Like About This Method:  This equation only calculates the size of a loan that we can theoretically afford.  It does not include the “TI” of “PITI””: homeowner’s insurance or taxes, which can vary widely by region.  In addition, this method does not take interest rates into consideration.  I would never advocate taking out a larger loan simply because interest rates are favorable. However, if interest rates were to rise to more typical levels (say, 5.75-6.25%), our mortgage payment could be several hundred dollars more than it would be at the current rates.  

We decided that both of these guidelines can be helpful starting points for calculating home affordability, but they should be not be used in a vacuum.  There are several other factors that influence home affordability, none of which are reflected in the two guidelines above:

Other financial goals/obligations: Depending on your/your family’s circumstances, you may have other financial goals or obligations such as childcare, college savings, or elder care.  We don’t yet have kids and our parents are in good health, so these expenses might not be an immediate priority when we first buy a home.  However, we want to be certain that buying a home does not preclude our other goals.  If we were to spend 28-33% of our gross income on housing, I think we would feel as though we weren’t saving enough for the future.  We would feel like we were living paycheck to paycheck, especially once we start a family.  That’s not a good feeling, especially when you’ve just committed to a long-term expense. 

Income Structure: Mr. W and I are both employed in full-time salaried positions.  Our income structure is straightforward: we do not receive bonuses or commissions, and we have very little side income.  However, we both work in relatively niche industries, so we do not think of our jobs as particularly stable.  If our employment situations were to change, it may take some time for us to find new positions and the new positions might be at a lower income level.  For this reason, we want to be conservative when calculating how much home we can comfortably afford.  If we had variable income streams, we would be more conservative when calculating home affordability, so that we would not be left scrambling in those months when the income stream comes to a trickle.  Finally, if we were a single-income family, we would be even more conservative than we are currently.  In that scenario, we would want to keep our monthly obligations even lower to allow us to build and maintain a larger emergency fund. 

Home Maintenance/Repairs/Utilities: Mr. W and I will most likely purchase a home that is 70-100 years old.  Given the age of our hypothetical home, it is bound to require more repairs –and costlier repairs – than a brand new home.  In addition, there is a chance that the home will be heated with oil, which is substantially more expensive than natural gas.  We will need to take utility and repair costs into account when calculating how much home we can afford.   

In the end, we used our own calculation to determine how much home we could comfortably afford.  We would feel most comfortable knowing that we can pay our mortgage and necessary expenses on the lower of our two take-home incomes.  We estimate that, if absolutely necessary, we could live on $600-750/month for our non-discretionary, non-mortgage expenses (groceries, utilities, gas, car insurance).  We did not include our car payment, as we plan to pay that off before buying a home.  Living on $600-750/month would not be an ideal scenario: we would be eating lots of ramen noodles.  However, we could make it work if necessary.  Thus, we used the following “back-of-the-envelope” calculation:

Maximum monthly mortgage payment (PITI) = lower monthly take-home income - $750


If we already had kids, we wouldn’t cut it as close as we did in this calculation.  We would build in some extra cushion when figuring out our non-discretionary monthly expenses.  In addition, our expenses would be much higher than $750 because we would need to pay for childcare, diapers, etc.  But for the time being, we think this is a good approach.  As with the above scenarios, we assumed 4.5% interest, a 30-year mortgage, and 20% down payment.  We also assumed $8,000/year for property taxes and $1500/year for home insurance.  The calculation resulted in a loan amount of approximately 1.66 times our combined gross income.  The mortgage payment would be 1.66 times our current rent .

The first mortgage guideline (28/36 housing/debt ratios) tells us that we can afford a home like this:
3 bedroom, 2 bath home on nearly half an acre.  Approx 1700 sq. ft. 
Built in the 18th century
This home would be perfect.  Really, it could be my forever home - historic, old, lots of character, beautiful lot, in the same neighborhood where Mr. W grew up.  With the exception of those oddly pruned shrubs, I love it.  The 28/36 ratio essentially tells us that we can buy our dream home within the next few years.  No way; we're not buying that.  This is a home that we could maybe purchase in the next 10-15 years.  Obviously, we haven't gone to any open houses for homes in this price range.

The second mortgage guideline (borrow up to 2.5 times your gross income) tells us that we can afford something like this:
4 bedroom, 2 bath home on .1 acres.  Approx 1900 sq. ft. 
Has a den, family room, and formal dining room. 
This is also a lovely home that we could grow into.  The interior needs a little bit of work, but it has plenty of space and a good layout.  It's in Mr. W's neighborhood, and I suspect that the price would be higher if the yard were larger.  But again, this is more house than we could comfortably afford at our current income level.  We haven't gone to any open houses for homes in this price range, either.


In the end, we determined that in a few years, we may be in the market for a home that looks something like this:
2 bedroom, 1 bath home on .1 acre. 950 square feet.
Has an office, but no dining room or family room

It's cute and charming, right?  This is definitely a teeny-tiny starter home, and it would be a tight squeeze if we were to have more than one child.  As you can see from the edge of the picture, the neighbors are quite close.  However, it's in our target neighborhood and it's a home that would not prevent us from achieving our other financial goals. 

There is a noticeable difference between the kinds of homes we feel we can comfortably afford and the homes that the guidelines say we can "afford."  What’s the reason for the disparity?  Quite simply, mortgage lenders are willing to lend as much money as a borrower can repay.  The more we borrow, the more they earn from us in interest.  Lenders aren’t interested in ensuring that we can meet our other financial goals or obligations.  They don’t care whether we can save for our kids’ college tuition, or plan for retirement, or care for aging parents.  And it’s not really their responsibility to care about those things, either; lenders are in the mortgage business to turn a profit.  However, we have to remind ourselves to run the numbers ourselves, independent of the guidelines provided by the mortgage industry.  It’s essential that we evaluate how a mortgage will fit into our big picture goals to ensure that we do not overextend ourselves financially. 


  1. The last time we bought a house (5 years ago), the mortgage company told us that we could spend three times more than we did. No, thank you! I had no desire to borrow that much money.

  2. JW_UmbrellaTreasuryJuly 10, 2013 at 6:28 PM

    Wow, three times more than you spent? That's a lot to borrow! Glad you went with a much more conservative approach!

  3. LOVE this thought process. I right there with you that the banks will try to get you much more house that you can likely comfortably afford. I personally think it's crazy to be throwing 33% of your income into your house, unless you have an incredibly high income. Our other goals are far too important and we would definitely be doing something similar to you in terms of price range.

  4. Student Debt SurvivorJuly 11, 2013 at 10:28 PM

    When we bought our condo they approved us for far more than we'd ever spend (a scary large sum of money). Thankfully we have common sense and realized we'd like to continue doing things like, well, eating and clothing our bodies. We also didn't want to have to give us on the little lifestyle things that we enjoy. In a few years we'll probably be able to afford the bigger single family place in the suburbs, but for now we're happy with our little city dwelling.

  5. My Shiny PenniesJuly 13, 2013 at 5:52 PM

    When I applied for a mortgage a little over a year ago, I was surprised by how conservative the numbers were. I think it may be because I didn't have a co-applicant. I determined the mortgage affordability based on my net pay rather than gross because like you said, there are are variables that determine how much a person actually takes home. The shrubs in that first house are...interesting. I wonder what the homeowners are thinking, lol.

  6. JW_UmbrellaTreasuryJuly 16, 2013 at 12:43 PM

    Matt, I completely agree that committing to spend 33% of one's gross income on housing is quite risky. What if employment conditions change or new expenses crop up? I like having more wiggle room than that - especially for those unexpected home-related expenses that we don't currently have to worry about as renters.

  7. JW_UmbrellaTreasuryJuly 16, 2013 at 12:47 PM

    Haha -- yes, food and clothing are quite important! And I agree that those little luxuries are important as well. My husband and I enjoy eating out and working out. We wouldn't want to have such a high mortgage payment that we had to give up those things permanently.
    We're pretty happy with our little place, as well. Every once in a while, I fantasize about having more room to spread out. But in all honesty, our apartment is completely fine for us right now.

  8. JW_UmbrellaTreasuryJuly 16, 2013 at 12:49 PM

    Tina, that's really interesting that the numbers were more conservative than you were expecting. Like you said, perhaps it was related to being a sole applicant.
    Aren't those shrubs weird? It's weird because the interior of the house is classic and timeless...and those shrubs seem so out of character in comparison.

  9. I would for sure have to buy a three-bedroom home because a two-bedroom home would not last very long if we had more than one child (which we plan to do). I know people that buy a two-bedroom as a starter with the intention of moving, but then never do or wait a lot longer than they anticipated and then they're cramped in this tiny home. My in laws for example have two children in a two-bedroom and the kids are now 9 and 5 and there is just no room in their house. If you're planning for more than one child, I would strongly consider a home that you can at least grow into.

  10. I like your analysis as to the pros and cons to each method. A lot of people like to just use the guideline as a general rule for everyone but everyones circumstances are different. I went to a bank recently to see how much mortgage I could afford and the biggest surprise to me was the closing costs!

  11. JW_UmbrellaTreasuryJuly 18, 2013 at 5:42 PM

    Ah yes, the closing costs. I've heard they can be around 3-5% of a home's value, if not a bit more. It's definitely something to plan for. I know some buyers are able to negotiate to have the sellers cover closing costs, but we don't want to count on that, especially as the market becomes more competitive.

  12. JW_UmbrellaTreasuryJuly 18, 2013 at 5:48 PM

    I agree with the idea of buying a home that you can grow into. Once we buy a home, we'll be looking for a place where we can stay for at least five years, if not longer. Also, our community is so family-oriented that 2 bedroom homes don't sell very well. If we bought a 2-bed home, I would worry about the resale value once we were ready to see. In a few years, if there aren't any 3-bedroom homes in our price range, we'll probably just wait a bit longer until we can afford one.