How Much A Month Can I Afford in House Payments?
Copyright 2009 by Morris Rosenthal - - contact info
Mortgage Math Workbook
Copyright 2009 by Morris Rosenthal
All Rights Reserved
Formula for Income to Afford a Home Mortgage Payment
The idea on this page is to give you (and me:-) an idea of the different factors are that affect a persons ability to make payments on a mortgage, especially in terms of income and and taxes. I did a whole page on the mortgage tax break, so I'll only give the financial examples here rather than explaining that background over again. Before we get to the tables, a word about rules of thumb. You may have heard that the best formula for house affordability is a multiple your gross income, conservative financial advisors would say you can afford a mortgage that is two times your gross income, more aggressive advisors in California or the East Coast may suggest three times your gross income, and you could do worse than settling in the middle, 2.5X gross income. Your gross annual income is simply your monthly income X12. The reason these formulas talk about the size of the mortgage you can afford rather than the actual cost of the house is because everybody brings a different down payment to the table. If you just sold a house or have saved or inherited a big bucket of money, maybe you can put down 50% or more of the house price. Even if your gross income is relatively low, the total mortgage amount may end up being so low that you can easily afford it.
The other thing to note about the formula is that it indicates houses are still vastly overpriced on both coasts. The median household income in the U.S. is just over $50,000, or a little more than $4000 every month, it's a little higher in New England, New York, New Jersey, California and a few other states, at around $60,000, or $5000 per month. Using the middle of the road formula or rule of thumb, that means the median household in the high income states can afford a mortgage around 2.5 X $60,000 or $150,000. Unfortunately, the median house price (half above, half below) in these states is still over $300,000. So how is it people can afford mortgage payments if they don't have sufficient income? That puzzle goes a long way to explain the housing crisis we've gotten into. Many, if not most people buying houses in higher price areas in recent years really can't afford to pay the mortgage based on their income, which is why they used all sorts of exotic mortgage products to get in the door. If those mortgage products hadn't existed, the people couldn't have afforded to buy homes at those prices and those prices never would have run up so high, the old supply and demand. But the people who have owned their houses more than five or six years loved it when prices shot up, it made them feel rich, and selling for much less than the peak makes them feel like they're losing money.
There is no short term solution to the pricing problem, the $8,000 tax credit for first time home buyers is a drop in the mortgage bucket. For most people looking for a house to live in today, renting simply makes more sense than buying. But if you do feel you need to buy a home, you should at least be aware of how much it's really going to cost you, and not beg, borrow and steal to raise the down payment, only to find yourself fighting foreclosure six months down the road. So the first step is to take a look through the tables below to get a grip on the numbers, starting with the basic monthly mortgage payment for a given principal (loan) amount. I'm including the interest amount for the first year, which is the highest year for fixed mortgages (you're a fool to buy a house with anything other than a fixed mortgage these days), and sets the maximum tax deduction you can get. I'm rounding off in the tables below, if the pennies make a difference in how much house you can afford, you need a shrink.
The tables above let you apply the affordability formula based on the mortgage principal, to see what it means in terms of a monthly payment for your budget, and to calculate the maximum tax benefit at the end of the year, which will be a tiny fraction of the interest paid that year. The basic formula you already know, just pick whether you are going with 2X (conservative), 2.5X (middle of the road) or 3X (optimist) and you'll arrive at the largest mortgage you should consider taking, regardless of what the bank or mortgage broker tells you. Note that the most aggressive, 3X your annual gross, amounts to one quarter (.25) of your monthly gross, which is another way to look at it. But keep in mind that the 25% of your monthly grosss is pre-tax, including pre payroll tax (7.65%) which all workers pay, no matter how low their income.
After the monthly mortgage payment, your biggest fixed expense for the house will often be the property tax (also called millage tax). In some states, the property tax is collected on the local level, which means you'll have to do some research to estimate how much house you can afford. California has a maximum 1% property tax at full valuation, making the median property tax bill a little over $3,000 in the state, while Florida goes to 3%. The main difference is that California has a high personal income tax and Florida doesn't, so they have to make the money somewhere. You'll find the same is true in the New England, where the highest property tax rates are generally found in New Hampshire, which has a very low income tax rate. States like New Hampshire, Massachusetts, etc, that charge property tax on a local basis, usually charge in terms of dollars per thousand. So a cheap town in Massachusetts may charge $10 per $1000, or 1% of the valuation, while an expensive town in New Hampshire may charge over $30 per $1000, or over 3% of the valuation. A great resource for comparing costs on a state to state basis is RetirementLiving.com.
People moving from a rental situation to a home owner situation often forget three expenses that make a huge difference in the monthly budget: Utilities (some of which are included in many apartments), insurance and property taxes. Utility costs vary tremendously through the US, with heating fuel being the predominant cost in the colder areas, and electricity taking the lion's share in the southern states. I'm not including extras like phone or cable TV because you likely pay those bills where you are renting. Heating costs in the Northeast add an easy $3,000 a year to the cost of living, and often much more. It depends on the size and insulation of your house, the temperature you set the thermostat, the fuel used and the fuel cost. Heating a large old house in the cold states can break $10,000 in a high fuel cost year. Now add on homeowners insurance, with a cost of around $800/year for the median value home in the US, and over $1,000 in some hurricane states.
Your real estate tax will likely run between 1% and 3% of the mortgage on an annual basis, unless you put down a very large down payment, in which case, the percentage will be higher since the mortgage will be smaller. While 1% to 3% may not sound like much, it makes a huge difference in the house payment you can afford, and the bank may try to force you to include the taxes in the monthly mortgage payment. Let's look at a $200,000 mortgage, a reasonable proxy for the average in the US. If you live in an state or a town with low property taxes, you can still expect to pay $2,000 a year above and beyond your mortgage. But if you live in an expensive property tax state or town, you can expect to pay around $6,000 a year in property taxes, or $500 per month! On a 30 year mortgage, the best real estate taxes will add more than 50% to your monthly payment if you have a 4% mortgage, just around 50% at 5%, or a little less at 6% . In all cases, that 3% property tax changes lowers the amount of house you can afford by around one third.
So another formula (I just invented it) is that your total cost of living in a home will be at least double your mortgage payment for the median priced home in a high property tax area, based on heating, taxes and insurance. These expenses will usually rise in relation to the mortgage for a lower cost home, because the heating and insurance costs aren't proportional to the value of the house. All of these factors go into those rules of thumb as to whether you can afford a house based on your income, but I hope this helps explain why the estimates range from two times to three times your gross income. If you live in a low property tax area with low heating, utility and insurance costs, you can be a little more aggressive than taking a mortgage for double your income, because the mortgage itself will be the main expense.
So now we get to the bottom line. How much can you afford per month for house payments today? The main wildcard we haven't talked about yet is the realtor's best friend, the mortgage tax deduction. That's why I included the first year interest in the tables above. Going back to the median, let's say you purchase a home with a $200,000 mortgage at 5%. You first full year deductible interest amount is around $10,000. This means when you file your Federal Tax return, you can itemize and add that interest amount to the real estate tax, your other state or local taxes, recognized charitable contributions, and a few other related expenses. If those taxes and other expenses add up to around $5,000, you to lop $15,000 off your gross income before paying Federal income tax. But here's the rub. If you are married an filing jointly, the standard deduction for 2009 is $11,400. In other words, the value of the itemized mortgage interest, tax and charitable deductions is only worth $15,000 - $11,400 to you, or $3,600. If you are married, filing jointly, and earning less than $67,900 in 2009 (and that's after the personal exemption and other tax credits), most of your income is in the 15% tax bracket, meaning that your actual cash savings for owning a house and itemizing expenses will be $540 for the entire year! Remember, it's not the size of the deduction that counts, it's the tax rate you pay, because the deduction only reduces the income you pay taxes on, it's not a tax credit. The mortgage tax deduction really only pays dividends for high wage earners living in expensive houses with big mortgages, but it has zero impact on whether or not the average American home buyer can afford house payments on a monthly basis.
Mortgage Math Workbook | Calculating Mortgage Interest | Mortgage Tax Breaks | Mortgage Payment Affordability | Calculate Mortgage Amortization | 13 Payment or Bi-Weekly Mortgages | Using Mortgage Tables | Solving for Interest Charged