The Deal Lucille

Aug 17 2009

Tips for First Time Home Buyers – Part #2

How to Determine How Much House You Can Afford

Notice I didn’t say how much house you can buy. There are all kinds of vehicles that will let you buy as big a house as you want. But, buying that big house and keeping that big house are two completely different things. Lots of people bought big houses. Lots of people are being foreclosed on. Because they bought more house than they could afford.

So, how do you figure out how much house you can afford?

Well, like everything else, there are some terms you need to know.

Mortgage. A mortgage is nothing more than a fancy word for a loan. In it’s simplest sense, it works just like every other loan: You borrow money from the bank, which then charges you a monthly fee (called interest) based upon the amount of money you borrowed.
Principle: The actual amount of money you borrowed, minus any money tacked on as interest.
Payment, or P: This is how you pay off your loan. Usually done on a monthly basis, payment includes payment on the principle and interest of the loan.
Interest, or I: The amount of money the bank charges you for lending you the money.
Taxes, or T: This is property taxes on the property you want to buy.
Insurance, or I: This is the monthly payment for home owner’s insurance, which all mortgages require you to have because, after all, in most circumstances the bank is fronting you the lion’s share of the money you’re using to buy the house. Therefore, they have the most to lose since they basically own some portion of the house until the loan is paid off.

Now that we have our terms defined, let’s get to the business of determining how much house you can afford. Let’s start with what I call the Magic Formula:

Payment+Interest+Taxes+Insurance, or

P+I+T+I

Okay, so what? I mean, I add all those things up, but what do they mean?

Well, nothing in and of themselves, because we’re missing the last critical piece of the puzzle, and that is:

What percent of your GROSS monthly income can you afford to devote to PITI every month? That answer, back in the day, when banks were banks and not financial investment institutions, was 28%. That meant that if your gross monthly income was $3,000 per month, your PITI could not be larger than 0.28(the decimal equivalent of 28%) X $3,000 (your gross monthly income), or $840 in this example. Anything over $840 per month back in the day, and you couldn’t get the loan.

This was good economic policy for both the banks and consumers, and that’s why I use it here. Yes, it’s conservative. But you will have a better chance of not getting in over your head if you use this formula than if you don’t.

So, let’s put our Magic Formula to the test on a real life situation.

Let’s say we see a beautiful, 6 year old house with 3,540 square feet of living space in Scottsdale, Arizona. I see from the online listing that the house is listed for $539,900. We’ll estimate property taxes at $300 per month, and we’ll estimate insurance at $200 per month. Again, we will assume we are not putting any money in as a down payment, so we want the bank to loan us all $539,900.

Using an online mortgage calculator, we calculate that P+ I at 5.33% interest for a 30 year fixed rate mortgage = $3,008.16. Adding $300 per month for taxes and $200 per month for insurance, we get:

P+I+T+I=$3,508.16 per month.

Now, we already calculated that we can afford a monthly payment of $840 per month, so you can see we’re way out of the ballpark for our Scottsdale home.

This is commonly known as sticker shock, in which you see the home you want and then realize you’re not even close to being able to afford it on our 28% of gross monthly income terms.

But, all may not be lost!

In the next post, I’ll talk about how we can use our knowledge of the P+I+T+I formula to try to improve our odds of being able to afford that house while still sticking to our conservative approach to risk.

See you then.

Like most bloggers, I live on comments. Please take a minute and let me know if this is helpful.