H.O.M.E.* Housing Costs:
How much can you afford?

*Home Ownership Made Easier

An extension publication of the Department of Economics and Housing
New York State College of Human Ecology
Cornell University
Ithaca, NY 14853

Guidelines

Just how well do these old guidelines apply to you in today's housing market?

• Housing should take about 25% of your gross pay or 35% of your take-home pay.

• When buying a home, look for something priced at 2.5 times your gross income.

Let's take a look at an average household with an average income. Early in 1988, the average gross income for US households was about $27,000; the average net income was about $24,580, based on the US Department of Labor's Consumer Expenditure Survey. Using the first rule of thumb, a household should be spending about $562 to $717 per month on shelter, utilities, and other housing-related expenses. If this same average household wanted to buy a house, according to the second rule of thumb, they should be looking in the $67,500 price range.

These budgets and prices may be practical in Buffalo, where the rent for an average two-bedroom apartment is $405 and the median price of a home is $55,000. In the lower Hudson Valley, however, where the average rent is about $740 and the median price of a home is $220,000, the average family probably will not be able to afford the desired housing using these rules of thumb.

Obviously, the old rules of thumb are not applicable in many of today's housing markets. The reality is that households spend between 21 and 54% of their gross income on housing, depending on age and income level.

Total Costs of Shelter

When thinking about how much you can afford, it's important to keep in mind not only the rent or mortgage payments but also all the other costs of running a household. These expenses include taxes, insurance, utilities, household operations (cleaning sup plies, postage stamps and the like), home furnishings and equipment, household maintenance and repairs, yard and garden supplies, and expenses related to remodeling or home improvements.

The average annual expenditure in the Northeast for utilities, household operations, and furnishings in 1988 was about $265 per month. The average total cost of shelter in 1988 in the Northeast was about $648 per month.

Your non-mortgage housing expense will depend on your lifestyle and the energy efficiency of your home. If your home is energy efficient, you may be able to afford a higher mortgage because your monthly utility costs will be lower. Your total shelter costs may be about the same, but they will be divided differently between the mortgage and utility payments.

The Lender's Perspective

When a financial institution reviews a mortgage application, it usually follows two basic guidelines in determining how large a mortgage to grant:

1. Principal, interest, taxes and insurance (PITI) should not exceed 25 to 28% of gross income, and

2. PITI plus other long term debt should not exceed 33 to 36% of gross income.

(note: to calculate principal and interest, you may use the Mortgage Payment Calculator.)

Long term debt includes car loans, installment loans, alimony, child support, and balances on charge cards that will take more than 10 months to pay off. Whether the lender uses the top or the bottom of the range depends on the size of the down payment you plan to make. For example, if you are paying 10% down, lenders probably will use the 28% and 36% figures; if you are paying 5% down, they will use the more conservative 25% and 33% figures. Some recent changes in the secondary mortgage market allow lenders to use the 28% guideline for all down payments. You can see how these limits translate into dollars in Table 1.

Upfront Costs

One way to reduce mortgage payments is to make a larger down payment. But most first-time buyers cannot afford to put all their savings into a down payment because there are "upfront" expenses that require cash. Many of these are closing costs (bank fees, points, insurance, escrow amounts, attorney fees, state and county fees, survey, title insurance, and inspections), which are discussed in a separate pamphlet. Other possible upfront expenses include moving costs, minor repairs and furnishings (towel bars, shelving, and so on), and money paid to the seller for items not included in the purchase offer (drapes, porch swings, special light fixtures, appliances).

Affording Your Dream Home

Many times, the homes you like are the ones you can't afford, and the ones you can afford you don't like. How much you "qualify for" and how much you can afford may be different. But you may be able to afford and buy your dream home if you are willing to put in a little time and effort. To determine how much you can afford it may be necessary to sit down with your financial records and add up how much you spend on all other non-housing items in your budget. Any remaining money could be used for housing -related expenses.

First, review your expenditures to see if you can make cuts in areas to shift more money into housing. Are you able and willing to spend less on clothing and entertainment so you can make larger mortgage payments? Can you go on a "crash budget" to save up for a larger down payment that will enable you to buy a higher priced home for the same mortgage payment?

Second, remember that you can deduct mortgage interest payments and property taxes from your income tax, which may help save on federal, state, and local income taxes. You can take these savings as a once-a-year tax refund or you can change your withholding exemptions and increase your take home pay. An accountant can estimate your tax savings and how they can help you afford a bigger home.

Third, make sure you have shopped around for the best mortgage interest rates and terms. Even half of a percentage point can make the difference between affording the mortgage payment or not. Consider an adjustable rate mortgage (ARM) because with its lower initial interest rate you may be able to afford a larger mortgage than you could with a fixed rate. Be sure to read Adjustable Rate Mortgages (for information on how to order, see List of Publications) to become familiar with some of the pros and cons of ARMs.

Fourth, consider alternative forms of home-ownership Equity sharing will reduce your mortgage expenses and make home-ownership affordable. In equity sharing, you take on a partner or co-investor to share the ownership and expenses of the home. For example, you and your parents may become co-owners of the house, although the co-owner does not need to be a relative. The costs will be split between both households, and both will share in the tax advantages and the appreciation of the property.

An equity-sharing agreement must be set up by a knowledgeable attorney, and you will need to make decisions about specific terms and conditions. For example, if you wanted to buy out your partner's share in the future and become the sole owner, how would you do it? Which expenses for maintenance and upkeep are shared and which are yours as the co-owner/occupant? How will records be kept, both for tax purposes and for accounting when you eventually sell the house? What restrictions do you want to put on the use of the house (for example, can your partner use his or her share as collateral for a loan?)?

Finally, remember that your first home may not be your dream home. Most families move several times over their lifetimes, trading up to bigger and better homes with each move. "Starter homes" allow you to build equity while continuing to work toward your financial goal of owning your dream home.

Written by:
Jeanne M. Hogarth, associate professor
Department of Consumer Economics and Housing
New York State College of Human Ecology
Cornell University, Ithaca, NY

with assistance from:
Kevin Berkley, vice-president
Citizens Savings Bank

Table 1

Qualification Guidelines

How Large a Loan Can You Qualify For?

1. Annual household gross income (find from last year's tax returns).
   Example: $40,000
2. Monthly gross income (divide line 1 by 12).
   Example: $3,333
3. Percent of income to be spent on long term debt, including housing (use .33 to .36; see Lender's Perspective, above).
   Example: .33
4. Multiply line 2 by line 3 (amount available for long-term debt, including housing)
   Example: $1100
5. Estimated monthly debt repayment (installment loans, charge cards, etc.)
   Example: $200
6. Estimated monthly expenses for property taxes, insurance, and utilities.
   Example: $285
7. Add lines 5 and 6.
   Example: $485
8. Affordable monthly mortgage payment (subtract line 7 from line 4).
   Example: $615
9. Monthly payment per $1000 of mortgage (the example uses a 30-year loan of $1000 at an interest rate of 9.5 percent. See the Mortgage Payment Calculator.
   Example: $8.41
10. Divide line 8 by line 9.
    Example: $73.12
11. Multiply line 10 by $1000.
    Example: $73,120
12. 1 minus the percent down payment (the example is a 5 percent down payment; 1 - .05 = .95).
    Example: .95
13. Affordable home price (divide line 11 by line 12).
    Example: $76,970