THE BLIND ECONOMIST NEWSLETTER ISSUE: HOW MUCH SHOULD YOU REALLY SPEND ON A HOUSE?

Even the experts don’t know for sure.

JULY 12, 2023

In the early hours of the morning, a question haunts the minds of many: how much of their income should be allocated towards housing costs? This dilemma often arises when a coveted house appears on the market, stirring both excitement and anxiety about affordability. Various sources provide different rules and estimates, but the answer remains elusive.

One commonly cited guideline is the 28 percent rule, which suggests that no more than 28 percent of a borrower's gross monthly income should be spent on housing costs. This familiar advice offers a semblance of reassurance, with its precise percentage acting as a comforting mantra.

However, there is another rule that takes into account all debts, including mortgages and student loans. This rule recommends that housing costs, along with other debts, should not exceed 35 percent of one's income. Extrapolating this, someone earning $60,000 annually with no existing debts could potentially afford a mortgage of $1,750 per month, amounting to a home valued at approximately $250,000.

Financial expert Dave Ramsey provides a different perspective, suggesting that no more than 25 percent of one's take-home pay should be allocated towards mortgage payments. However, with the current historically high interest rates, it is uncertain if houses within this budget range still exist.

The question of how much one should spend on a house remains open-ended, with varying advice and no definitive answer. It is crucial for individuals to carefully evaluate their financial circumstances, consider their long-term goals, and make an informed decision based on their unique situation.

As a former CEO of e-mortgage Corp. and a financial consultant to clients ranging from high net worth individuals to young couples just starting out, I have had the opportunity to assist individuals at various levels of financial stability. In most cases, the fundamental principles remain the same.

It is important not to fall victim to the fear of missing out (FOMO) epidemic and instead focus on what is practical for your specific situation. While the housing market has historically been a significant wealth builder for families over the past century, it is crucial to remember that past performance does not guarantee future results. In many parts of the country, it may actually be more cost-effective to rent a home rather than purchasing one.

Therefore, we should not view homeownership as a requirement in life, but rather as a means to fulfill our housing needs. It is essential to assess the costs associated with housing and make a decision based on what makes sense for our individual circumstances.

Let's conduct a basic economic analysis using available data. In 2022, the average income in the United States, measured by GDP per capita, was $74,400 per year. It is important to note that this figure represents pre-tax income. To determine the average monthly income for a single person, we divide this value by 12, resulting in $6,200 per month.

However, our focus here is on evaluating housing expenses rather than the feasibility of purchasing a home. According to the Department of Labor and Statistics, a second income in the average household amounts to about $4,100 per month. Taking this into consideration, the average household income would be $10,300 per month.

It is worth noting that a second income source in today's context may not necessarily come from a partner but could instead include other family members, such as in-laws, who reside in the same household. This additional income contributes to the overall financial capacity of the household.

From an economic viewpoint, given the computations previously carried out, a household could potentially afford a maximum monthly housing expense of $2,884. 

It is important to contextualize this sum according to standard parameters set by mortgage institutions. Specifically referencing data from Freddie Mac and Fannie Mae, this expense aligns with their EA-1, or tier 1 loan standards. 

However, achieving this loan platform isn't solely about income. Other relevant factors include a robust employment history, provision of a down payment of at least 10%, and a credit score of 740 or higher. These are key requirements to financially qualify and, in turn, afford this level of monthly housing expense.

Certain essential queries warrant our attention, belonging inexorably to the current housing market context. A primary question often revolves around the basic desire for an indoor living condition, an aspiration that, in general, tends to receive an affirmative response.

Indeed, the dynamics of today's housing market necessitate adaptability, akin to a proficient sea captain adjusting to varying marine currents. It calls for contemplation on two pivotal factors:

The first pertains to the feasibility of homeownership.