April 3, 2012

Can You Afford A Home?

April 3, 2012

Can You Afford A Home?

Money manager and blogger Barry Ritholtz is “Debunking The Housing Recovery” a five-part series this week. Today’s piece is on affordability and the main premise was not so much debunking home affordability as debunking the NAR’s Affordability Index.

So I just wanted to add a couple points for consumers on the ground. Granted, as a retail mortgage banker my view of the world is very localized. But that’s where money is made and lost in housing.

Investment pros tend to view all asset classes according to efficient market theory: the premise that asset prices incorporate and reflect all relevant information to all market participants. And as such, broad macro (aka national) measures are often used to analyze housing.

I’d argue housing is different from traditional asset classes like stocks and bonds.

The macro picture is relevant as a broad housing benchmark, but real estate is incredibly inefficient at the local level. Meaning not even close to all information is available to all market participants.

So you have to find and price deals one neighborhood and one house at a time. Something money managers call bottom-up analysis or security selection.

The two main considerations of home affordability are market and personal.

The market consideration is whether it’s cheaper to rent or buy a home. The personal consideration is whether you can actually afford it.

I’m addressing market considerations in a separate series on local home price analytics (versus the national analytics which dominate the media discussion on housing). Here’s the latest, and the follow up on appraisals will come along with the next Case Shiller home price report.

As for whether you can actually afford a home, it’s largely based on something lenders call a debt-to-income ratio or DTI.

DTI isn’t just the most important determinant of affordability for lenders, it’s also very useful for you to make decisions.

DTI is your housing debt plus all other non-housing debt (like payments on student loans, credit cards, car loans/leases, etc.) divided by income.

The resulting percentage tells you how much of your income is going to housing and other debt.

Lenders will let you go up higher than most people should probably go.

If you’re getting a ‘conforming’ loan to $417k, your DTI can go up to 50%.

If you’re getting a ‘super-conforming loan to $625k (by county), your DTI can go up to 45%.

If you’re getting a ‘jumbo’ loan above $625k, your DTI can go up to 41-45%.

However, the DTI that’s not going to have a big lifestyle impact after tax benefits (deductibility of mortgage interest and property taxes on a primary residence) is 37% or less.

And you’ll want to shoot for an even lower DTI if you’re making assumptions like:

– primary residence tax deductions may go away in the future

– you or your spouse may choose (or be forced) not to work and/or earn less in the future

Like all financial matters, the rest is in the details of how you’re calculating DTI.

There are huge DTI calculation variances among borrower profiles. Variances include:

– Straight salary vs. salary plus bonus or commissions

– Self-Employed earners (sole proprietors aka 1099 earners)

– Self-Employed (company owners or 20%+ partners)

-Investment income (dividend, interest, capital gains, etc.)

I’ll cover these details in a follow up piece as well … but please note, I’m not as fast as Barry. He’s the financial blog king, as I’ve just reaffirmed today.
Further Reference:
Home Affordability Reality Check (Barry Ritholtz)

‘Everything Is Fine’ With Blog King Ritholtz