House Price to Income Ratio?

leafy02April 24, 2010

When we were shopping for our first home (1999-2000), I remember reading that a good way to set your price range was to multiply annual income by 5. So, if you made $100K, a house in the range of $500K.

It's not the formula we used because I'm a tightwad, we have four kids with all the attendant expenses, and we wanted to make sure we could afford to live on one income.

Now I'm starting to plan our next house purchase, or a remodel instead, and I'm wondering if that formula is the thing that got people in trouble with their mortgages, or what rule of thumb I should use in considering a price range. I'm trying to figure out if we'd be better off to make some changes to this place or just find a house that already has them.

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I had always heard a mortgage of no more than 2.5 times salary. The price of the house doesn't matter if you have the cash. It would probably be best to determine your own particular budget rather than go with a rule of thumb. Whip out the calculator. Look at mortgage, taxes, insurance, etc. Then decide your price range.

    Bookmark   April 24, 2010 at 6:20PM
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I don't think banks today use that ratio anymore, if they ever did!
We have bought and sold several times in the last 30+ years and I believe it was closer to 2.5 of your annual salary/salaries, and that was with a 20% down payment! (Unless you were fortunate enough to get a VA loan or similar).

    Bookmark   April 24, 2010 at 7:07PM
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Okay, thanks. Maybe I got that 5x rule from some flaky source and it's just always stuck in my mind because it seemed so dramatically different than what I thought we could afford. I know other people have different comfort levels with debt, etc., but it seemed like a big difference.

2.5 is more along the lines of what we did, so that makes sense.

    Bookmark   April 24, 2010 at 8:10PM
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Yes, I believe it was closer to 2.5 and that was what it was when we bought our first detached home back in 1974. The difference between then and now, however, was the debt of the average family. It has steadily risen over the years, so that the incomes translate to less disposable income for moving 'up'.

    Bookmark   April 25, 2010 at 11:01AM
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The only formula I have heard about is the monthly payment being no more than 30% of your monthly pay. Any ratio based on x times annual salary is meaningless because it does not take into consideration your down payment and, most importantly, the interest rate.

    Bookmark   April 25, 2010 at 11:35AM
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I agree with Clemrick, though would add, real estate taxes can be anywhere from 500-15000 depending on wher eyou live, so that can change how any of these equations.

Also, anything based upon income can be fine for a high level bank review, but for your own situation can be very flawed. for one, it doesn't include your down payment, your other debt, whether it be car, student loan or credit card. It also doesn't cover how you earn your income. If you are commission based with highs and lows conservative works better. Also, if there are significant child care costs involved that can have a big impact on the calc. ie: 100K from 1 earner is different than 100K total from 2 earners as the 2 earners have child care costs involved.

    Bookmark   April 25, 2010 at 11:56AM
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The threshold used for "affordable" in most government programs is 30%. No more than 30% of your total income should be spent on housing. Remember though, that 30% is for housing costs, not just the mortgage. You will have taxes, insurance etc too.

Of course, there is no rule that applies to everyone. If you make $100 million a year, it would be pretty insane to spend $30 million per year on housing. If you make $20k per year, spending 30% on housing probably means you will be eating rice and beans to get by.

    Bookmark   April 26, 2010 at 8:58AM
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Your TDS (Total Debt Service) ratio is taken into account by most lenders too. It includes not only mortgage debt, burt other instalment debt--credit cards, vehicle payments etc. The benchmark most often used is 40%.

Here is a link that might be useful: Total Debt Service Ratio

    Bookmark   April 26, 2010 at 9:19AM
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And the percentages increase at some lenders as the income increases.

If you earn $10,000,000 a year, you can probably afford to spend a lot more than 30-40% of your income servicing debt.

    Bookmark   April 26, 2010 at 10:13AM
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Well here is the formula we have used for over 30 years. It came from my in-laws. My mother-in-law sold real estate for over 25 years in the state. It seems a little simpler than most and I find it easier to understand.

25% of you gross monthly income for your mortage payment, 33% of your monthly income for all expenses (includes the mortage) on the house, ie - taxes, utilities, insurance & etc. Now if you want to play it very safe, use your net income per month instead of your gross income. This lowers your monthly payment but allows you some wiggle/ breathing room.

It's worked for us and our son and daughter-in-law are using it successfully.

Hope this helps.

Enjoy the journey.
eal51 in western CT

    Bookmark   April 26, 2010 at 6:18PM
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