It’s inevitable that as spring approaches an increasing hoard of buyers will be flocking to the real estate market. The biggest question everybody’s got in the front of their mind, way ahead of whether or not they’ll find the right house or can get into the best school districts, is how much they should spend on their homes. I can see it on your face — you’re asking yourself the same thing right now, and rightly so.
How much you spend on your house speaks as much to your financial future as what kind of house you spend that money on. Like so many things in the world of finance, though, there’s no one simple answer.
What Does an Average Home Cost?
The phrase “average home” is a bit of a deadly one to use, since what’s normal and expected in my area may be wildly huge or unnecessarily over-built for yours. So when we’re talking about average, we’re speaking of the home that’s at a middling price point. That’s all — I’m not even going to try to tell you what kind of home is normal for your area. It’s important to know what an average home costs, though, especially when you’ve got to decide what your upper spending limit is.
The main advantage to buying an average home comes at resale time. Not only will your home be in an “average” neighborhood, but the bulk of buyers will be looking for a house at your home’s price point (assuming there haven’t been any drastic shifts in neighborhoods during your ownership). See, buyers fall along a bell curve, with a much smaller group looking at the ultra cheap and ultra expensive properties. Your “average” home is going to get the most looks by far, and that helps get a fast and hassle-free sale down the road.
As of Fourth Quarter 2014, the National Association of Realtors reports that the average national home price is $208,700, with homes in the Northeast averaging $246,300; those in the Midwest averaging $162,000; houses in the South coming in at $183,500 and homes in the West averaging $299,500.
It may help to ask your Realtor about your specific market’s average price point if these prices seem out of line with your reality. Sometimes these broad averages don’t tell the whole story. For example, I’m included in the Midwest pricing, but the average house in Springfield, Missouri is actually hovering at $120,500 — a full $41,500 less than the regional average. If you’ve not yet chosen an agent, the link above includes data on a number of metro areas, choose the one closest to you to get an idea about your area’s average prices.
A Primer on Income Ratios
Now that you know what the average home costs in your area, you can start to figure out how much home you can actually afford. This may sound like basic stuff, but clearly you have no idea how many people don’t do this before looking at homes. There are two numbers you’ll have to pay particular attention to: the front-end ratio and the back-end ratio. Both are vital to determining how much home you can actually afford — and your lender typically uses both to decide how much they’ll loan to you.
Let’s figure a few. First, the back-end (I know this seems backward, but stick with me). Depending on the loan program you’re using, you’ll be allowed a back-end ratio of anywhere from 36 to 43 percent before manual underwriting is required. The back-end ratio includes all your debts, including your future house payment, so it’s a pretty important number.
Start by taking all your monthly contractual debt payments, excluding your current rent or mortgage if you will sell your existing home, and adding them together. This would include things like student loans, automotive loans, personal credit lines, credit cards, store credit lines, child support and so forth. Divide that total by your gross income. The number you get isn’t a true income to debt figure, but it’ll help us figure the rest of them.
Let’s say that your gross income is $4500 a month and your debts total $350. When you divide 350 by 4500, you get 0.078, or about 7.8 percent. That’s actually not a bad place to start.
350 / 4500 = 0.078 or 7.8%
Next, take your income and multiply it by your loan program’s back-end ratio. If you’re trying to get a Conventional Loan, for example, you’d multiply 4500 by 36 percent. What you get is the total amount your back-end expenses can total, including your new house payment. In our example, this number is $1620.
4500 * 36% = 1620
With all of these numbers in hand, we can now calculate how much house you can afford, according to your bank. Remember, in real life, this figure will include insurance, taxes and any other fees your escrow account would pay each year.
While we’re juggling, we’ll also have to keep a number called the front-end ratio in mind. This is the maximum amount of your income that your lender believes is appropriate for a house payment. For the Conventional Loan in our example, the payment is capped at 28 percent of your income. If you multiply your gross income by 28 percent, you’ll get a figure that represents the monthly payment your lender would allow if you only had minimal debt.
4500 * 28% = $1260
If, when you add this figure to your other outstanding debt, you’re still under the 36 percent number ($1620), you’re ready to go — that’s the payment your lender will allow. A quick visit to a mortgage calculator can help you estimate how much house that actually is.
In our case, that’s about a $180,000 loan with a four percent interest rate and no homeowners association fees. In the Midwest, this is a total slam dunk — you can find that home easily unless your list of expectations is a mile long and you absolutely must be in the most prestigious part of the city (this is why it’s good to know average prices).
What would happen, though, if you had a little more monthly debt — say twice as much? Now, instead of simply figuring on your payment being 28 percent of your income, you’re going to have to make your back-end ratio work, too. This isn’t too tough, just subtract your total debt from your back-end ratio maximum. In this case, take $700 from $1620. Since that number ($920) is less than your 28 percent front end maximum, it becomes your total payment.
| Scenario 1 | Scenario 2 | |
| Monthly Income | $4500 | $4500 |
| Monthly Debt (minus housing) | $350 | $700 |
| Front End Ratio | 28% | 28% |
| Front End Maximum | $1260 | $1260 |
| Back End Ratio | 36% | 36% |
| Back End Maximum | $1620 | $1620 |
| Monthly House Payment (PITI) | $1260 | $920 |
| Estimated Loan Amount | $180,000 | $130,000 |
Increasing Your Odds
I’m never going to tell you to buy more house than you can afford — but sometimes we have to do what’s right for us in the long term. Maybe you’re in a new job or just finished school and anticipate your income to increase in a few years, or you’re about to pay off a loan and your debt’s decreasing. Or maybe you know you’ll soon want to get married and start a family — adding another income to the household and requiring a great deal more space than you’d ever need on your own.
In situations like these, it may be worth it to stretch your dollars with programs that will allow larger ratios. You already know how to calculate them, so go ahead and see what happens to your allowable payment if you’ve got FHA’s 31 percent front-end and a 43 percent back-end to work with. I’ll put our sample numbers into the chart below.
| Conventional | FHA | VA | USDA | |
| Monthly Income | $4500 | $4500 | $4500 | $4500 |
| Monthly Debt (minus housing) | $350 | $350 | $350 | $350 |
| Front End Ratio | 28% | 31% | N/A | 29% |
| Front End Maximum | $1260 | $1395 | N/A | $1305 |
| Back End Ratio | 36% | 43% | 41% | 41% |
| Back End Maximum | $1620 | $1935 | $1845 | $1845 |
| Monthly House Payment (PITI) | $1260 | $1395 | $1495 | $1305 |
| Estimated Loan Amount @ 4% | $180,000 | $200,000 | $215,000 | $187,000 |
The Bottom Line: Buy the House You Need and Can Afford
There’s nothing like non-advice to take the place of something useful, but when it comes to how much to spend on housing, that’s a very personal, very subjective area. You want to spend enough today that you can afford the home that will carry you into tomorrow, but you don’t want to break the bank because the roof will spring a leak at some point and that’s going to hurt if you can’t save a little back every month.
Ultimately, if you were my client or even a close friend, I’d tell you to buy the best house you can for the least amount of money. If that means choosing an incredibly ugly fixer upper that has new air conditioning and a new roof for $25,000 less than its updated counterpart or selecting a slightly less prestigious neighborhood and saving $10,000, that’s what I would do — always and without exception.
Some people see their home purchase as an exercise in prestige, but you can’t afford to think that way. Your home is just that — it’s your home. It’s a place to live, to shelter you from the cold and to protect your family from the world outside, but it’s not a trophy to flaunt. The days of conspicuous consumption are behind us, they took with them our innocent belief that the market would never fail us. For your family, for your future, choose the house you need and pay what you can comfortably afford.