Good question, and it’s one that I’ve heard before.
The most common response I will give to a buyer client is to get pre-approved for a mortgage first, and see how your debt-to-income ratios fare. This is a great way to see how much of your money is going out the door every month, which can also be based on the new home you may buy, as compared to how much money is coming in the door every month (aka “debt” vs “income”). It’s also one of the most important tools that lenders use to gauge risk before approving a new loan/mortgage.
Please bear in mind that DTI ratios mostly account for liabilities found on your credit report (e.g. car loans, student loans, other mortgages, etc), and do not take into account other common monthly expenses (e.g. cell phones, groceries, gas, etc).
Which means you have to be careful. Just because a lender gives you a written letter stating that you are pre-approved for a certain maximum price, doesn’t necessarily mean you should go out and buy something at that price ceiling. There are other things to consider (e.g. jobs, kids, social amenities, etc). This is where your real estate agent can help.
“Okay, Tim. Even if my ratios are at a low-risk level, according to the lender, how do I know if where I am buying is considered affordable to the general public?”
That’s an even better question, and here’s a great place to start.
The National Association of Realtors, or NAR as they are commonly referred to as, has a formula to calculate those numbers; it’s called the Housing Affordability Index (HAI). Personally, I feel that HAI is not only a great tool for those looking to relocate from one US city to another, but also for those living in certain metropolitan areas that want to learn more about their hometown’s current affordability index.
Here is a great explanation of HAI, from the article that inspired this post:
“It is an index number that gives consumers an idea of their home-purchasing power in that area. The number indicates the ease of qualifying to buy a median-priced home considering typical incomes and market conditions there.
“The National Association of Realtors® (NAR) uses a formula to yield a single number to express HAI in an area. It is based on the relationship between median home price, median family income, and average mortgage interest rate. The higher the index number, the greater the household purchasing power. Record keeping began in 1970.”
So as to compare Philadelphia to similar metro markets in the area, because you all know I love to compare/contrast Philly against other major metros in the Northeast, our index was sitting at 203.4 as of 2012; remember, higher is better and 100 is the average. The NYC/Northern NJ area was at 114.2, and the DC/Northern VA area was at 167.9. So as you can see, Philadelphia is considered more affordable than our closest major neighbors to the north and south based on the HAI formula. It also means that incomes are higher than prices, based on local market conditions.
And there you have it.
Not only does HAI present an accurate portrayal of how affordable a certain geographical area may be (feel free to look up your local metro here), but it helps educate consumers before making the decision to move and/or buy. At the end of the day, tools like HAI are helpful in making one of the most important decisions of your life.
Since choosing real estate as my long-term career, and working with many buyer/seller clients, my advice to all of you readers out there would be to not only make sure you buy a home based on what works best for you and your family, but to also make sure the expense of a home fits comfortably within your budget.