Can You Afford That House?

The COVID-19 pandemic and resulting recession have caused a lot of people to think deeply on their financial goals as they relate to home ownership.

Unfortunately for many who have faced an unexpected income interruption, the dream of buying their first home will likely need to be delayed until they can resume employment and then prove to lenders that their income is back to a sustainable level. For those of us fortunate to be able to continue our careers working remotely, we have had more time than we could have ever imagined sitting in our homes and wondering what we might prefer different from our current living situation in the years ahead.

This recession is unique in that there are two conflicting forces related to home affordability: Nationwide home prices are holding firm near record highs, but mortgage interest rates have dropped to record lows. Below is a chart of a home price index for the largest 20 U.S. cities compiled by Standard & Poor’s:

This index began in January 2000, so the index shows price movement relative to that date. Note how the index rose more than 100% from 2000 to 2006 but then abruptly fell more than 25% through early 2009 during the Great Recession. Notice in 2020 how well home prices have held up through June during the COVID-19 pandemic.

The following table shows a nationwide average interest rate for a 30-year fixed-rate mortgage as compiled by Freddie Mac’s Primary Mortgage Market Survey:

While home prices remain elevated, lower interest rates are enticing those who are financially capable of making that next step to call their banker and get the mortgage process underway. Banks will look at your personal finances carefully to determine if you qualify for taking out a new loan, either for your primary residence or a vacation home. They will compare your earnings relative to your ongoing debt obligations to compute some ratios that you will likely need to fit within for loan approval:

Consumer Debt Ratio: Monthly Nonhousing Debt Payments ÷ Monthly Net (After-Tax) Income = Keep Under 0.20

For example:

  • Monthly minimum payments on student loans, auto loans, credit cards = $1,200
  • Monthly paycheck after taxes = $7,000
  • Consumer debt ratio = $1,200 ÷ $7,000 = 0.17 … This is below 0.20, so that is good

Housing Cost Ratio: Monthly Nondiscretionary Housing Costs ÷ Monthly Gross (Before-Tax) Income = Keep Under 0.28

For example:

  • Monthly mortgage payment, property taxes, home insurance, association fees = $2,500
  • Monthly paycheck before taxes = $10,000
  • Housing cost ratio = $2,500 ÷ $10,000 = 0.25 … This is below 0.28, so that is good

Debt-to-Income Ratio: All Debt and Housing Costs ÷ Monthly Gross Income = Keep Under 0.36

For example:

  • Combine the above items: $1,200 + $2,500 = $3,700
  • Monthly paycheck before taxes = $10,000
  • Debt-to-income ratio = $3,700 ÷ $10,000 = 0.37 … This is above 0.36, meaning one of the following: You will need to pay off some auto/student/credit card debt to qualify for a loan, your mortgage may be subject to a higher interest rate, or you should consider a lower-priced home

Assume that you will need to reinvest 1% to 2% of the home value back into the property each year in ongoing maintenance and repairs, so have that factored into your ongoing budget ahead of time.

You should also make sure that the overall expenses with homeownership still allow you to pursue other financial goals, like saving roughly 15% of your pre-tax income for retirement savings and having adequate cash flow to save for kids’ college education. The same analysis can apply to a second home purchase if you just add the additional expenses of the second home on top of your primary residence costs to see if the above ratios are still satisfied. If the numbers look good with the value of the home you want to purchase, and the home purchase would not impede your other financial goals, then approach several local banks to get some loan quotes and review bankrate.com to review quotes from nationwide providers.

Young professionals should focus on a 30-year fixed-rate mortgage to lock in a low rate that isn’t subject to rate increases and that will stretch out the repayment horizon so that your monthly payment is lower. This will allow you to have additional monthly cash flow that you can add to your retirement and investment accounts, which over time should earn a rate of return higher than your mortgage interest rate. In other words, paying the minimum payment on your mortgage and investing the rest should serve you well over a long mortgage term.

For midcareer professionals considering upgrading homes or buying a vacation home, it may make sense to pursue a 15-year mortgage so that your mortgage payment is scheduled to end once you approach your targeted retirement date.

Reviewing these specific decisions with your financial advisor within your comprehensive financial plan can help you review the various options to hopefully give you confidence in your decision. Please reach out to your advisor if we can help run some scenarios for you!

Travis Boyer, CFA, CFP®
Senior Financial Advisor

Share:

Share on facebook
Share on linkedin
Share on email
Share on print

Recent Posts:

Pay Off Debt? Or, Save for Retirement?

Fifty-six percent of adults under the age of 44 have student debt, according to the Pew Research Center. This is the highest share in history. The increase in college costs and the rising importance of a post-secondary education for improving income are a big part of this. Many surveys conducted in recent years have discovered that Millennials share a resistance to debt, no doubt influenced by coming of age during the dot-com crash of 2001 and housing crisis of 2008. Given this, it’s no wonder we often see younger people want to pay off debt before they save for retirement.

Why Your Money Isn’t Available Immediately After Selling Securities

When you need to withdraw cash from your investment account and you’re told the funds aren’t available, it can be a little unsettling, particularly when you know you have more than enough to cover the withdrawal. “What do you mean, the funds aren’t available? I can see them right there!”

2020 Newsletters:

Finding Your Passion Edition

Please enjoy our latest quarterly newsletter where we discuss various types of passions and the respective financial components, including traveling, leaving a legacy, helping others and serving our country, among others. As our CEO Rick Manske wrote, “We all know people who have passion. It is admirable and it can be boundless. I hope that you all know your passion. And if you are looking for it, I believe you’ll find it among your value set.”

Graduations Edition

Whether it is for you or a loved one, a graduation is a truly special moment to celebrate the accomplishment at hand and look forward to the future. As you’ll read in this newsletter, graduations are just as much for parents who are graduating from one spending level to another and adjusting to the new financial demands of the next advancements along the educational path.

Whitepapers:

Get updates from parsec financial

Scroll to Top