When we talk about affordability in real estate, we are usually referring to a whether a consumer has the capacity to afford a house.
And if so, how much or how big a house that might be.
This affordability is expressed in terms of the maximum loan-to-value (LTV) he can qualify for, and the maximum loan quantum a lender is willing to offer.
For example, if a home buyer is approved for a loan of up to $90,000 at 90% LTV, the highest purchase price of a house that he can reasonably afford is $100,000.
This doesn’t take into account closing costs and also implies the he would make a $10,000 cash down payment.
When getting ready to buy a house, it makes perfect sense to ask yourself “How much house can I afford?” so that precious time is not wasted on exploring dream homes that you cannot afford to buy… yet.
Calculating maximum affordable price
While there are countless methods to calculate how much a house an individual can reasonably afford, the 3-rules method is a method that is used by various professionals in the real estate industry.
It consists of:
- Income rule
- Debt rule
- Cash rule
Even though it’s accuracy can sometimes be wide off the mark due to assumptions used in calculation, the estimate it provides can be very useful for home buyers, agents, and other professionals.
The income rule is set by lender indicating that the borrower’s monthly housing expenses (MHE) cannot exceed a certain percentage of personal income.
The percentage is not a standard and differs from lender to lender and bank to bank.
The housing expenses consist if items like property taxes, insurance premiums, mortgage installment, etc.
For example, if a lender has the income ratio set at 30%, and a borrower has an income of $5,000 per month, the monthly housing expense cannot exceed $1,500. If insurance and taxes come up to $300, the maximum mortgage payment the borrower can afford is $1,200. On a mortgage at 7% interest over 30 years, that will support a loan of approximately $180,000. If a 10% down payment is required, the maximum price of a house that the borrower can afford will be $198,000.
The debt rule, again with the lender in focus, stipulates the maximum percentage of income a borrower’s debt can make up.
What items make up debt varies from lender to lender. But they are referred to at total housing expense (THE).
Some would include the housing expenses as stated in the income rule, while some only take into account recurring debt liabilities like personal and auto loans.
Whatever the case, the projected mortgage payment will make up a portion of debt.
Going back to the previous example, if debt ratio is 35%, and only the existing debt liability of $500 per month is taken into account, this leaves the maximum monthly mortgage at $1,250. At 7% and 30 year term, this works out to a maximum loan of approximately $188,000. Assuming a down payment of 10% cash, the maximum a buyer can afford for the house will then be $208,888.
The cash rule is the simplest rule to understand.
As buying property requires cash for the down payment and settlement costs, how much cash a potential buyer has on hand will easily dictate how highly priced a house he can afford to buy.
So if the borrower has $18,000 in the bank. At a down payment requirement of 10% will put his maximum affordable price at $180,000.
When the results generated from the 3 rules converge, for pragmatic purposes, the lowest of the 3 serves as the best estimate of how much house a buyer can afford.
In the case of the example above, the cash rule with $180,000 turn out to be the lowest, it is the affordability estimate for the borrower in question.
Limited by affordability rules
From the example, when a borrower’s affordability is restricted by the cash rule, he is said to be cash constrained.
Some mitigating factors to raise the estimate include:
- Negotiating for a lower down payment
- Haggling for reduction in settlement costs
- Obtaining more funding for down payment
As the saying goes. Cash is king.
For debt constraint home buyers, the obvious solution to boost loan quantum is to clear off some debt.
Sometimes a personal loan for example has only a few more payments left. By fully settling it, a borrower can decrease the debt ratio and greatly increase the maximum loan amount.
Some lender do allow the waiver of debt when there is less than 6 months left on the debt.
In this case, do present documentation as evidence to the lender that a debt would mature in the short term.
When the maximum sale price is limited by the income rule, the borrower is said to be income constrained.
To raise maximum loan approval, the borrower can either decrease housing expenses or increase qualifying income. Or do both.
There are various ways to raise qualifying income. People in general are not aware of them simply because home buyers often times buy a house they can comfortably afford with the household budget.
So their income easily qualifies them for a mortgage to buy a specific house without needing to stretch their limits.
But in order to buy the most expensive house an individual can afford, there are some ways to improve qualifying income:
- Declare and submit documentation of housing allowance, transport expense claims, and other monthly monetary benefits provided by the employer
- Passive income from rental property, dividends, and other assets
- Get your spouse to go to work
By using the 3-rule formula to work out home affordability estimates, it is critical to keep in mind that there are no standards to income ratio, debt ratio, and cash down payment percentage used in the real estate industry.
While some numbers are widely practiced, they are not carved in stone.
Lenders apply their own numbers at their own discretion.