Monday, December 31, 2012

WHAT IS AN "AFFORDABLE" HOME?


It's somewhat ambiguous, but the definition of affordability has to be related to income, right?
Income as well as other debt & obligations.  But then we're getting into personal details...

Affordability is relative

Whose home are we talking about?  The queen of England?  A single parent in Bangladesh? An extended family of twenty-five in Sicily?

Buckingham Palace
Image courtesy of Robert Scarth
"Sewing Machine Lady" in Bangladesh
Image courtesy of Melanie Ko

I guess for the purposes of the post we'll make an assumption of a middle class American family.
Our modern standard of living has risen so high in the last couple of generations that most of us cannot even comprehend the living conditions of our own grandparents!

Should we feel guilty about this?  I don't know much about guilt;  I'm not really a fan of guilt as a motivating emotion. But I do think I can say unequivocally that we should aspire to:
  • free ourselves from competing with the Joneses,
  • find what is actually affordable for our own situations,
  • avoid burying ourselves in a mortgage we will never pay off, and 
  • avoid mortgage payments that will take up so much of our paycheck that other expenses are put on credit.


House Price as a Multiple of Earnings

To judge affordability of the housing market, some metrics compare the average home price and the average salary in a given are.  For example, in 2014, the average London home cost 16x the average Londoner's salary.  Averaged across England that multiple dropped to 10
But just the previous year, the multiple in the UK was 7.0, with counties averaging from 5.92 to 14.35.
Interestingly, the housing federation doesn't assert what affordability ratio they see as acceptable.  Only that in the 1960's the ratio was at about 4.5.

Forbes calls this the price-to-income ratio.  In a report on a 2013 Zillow study, 30 U.S. metro areas were shown to have a ratio ranging from 1.5 (Detroit) to 7.0 (San Jose).


Financial Fitness

I read a book on personal finance last year called The Total Money Makeover: A Proven Plan for Financial Fitness by Dave Ramsey.
Dave's first book, Financial Peace: Putting Common Sense Into Your Dollars and Cents, explains WHAT to do with money.  It is a guide to commonsense money management that is currently used as a textbook in some high schools.  The Makeover book is more about HOW to do the things described in the Financial Peace book.
I was totally stunned by the principles referenced and the hows to get there; it woke me up and asked, "What were you thinking?!!"


Mr. Ramsey's Seven Baby Steps

"Baby Steps" image courtesy of
Fire At Will
One of my favorite, and most basic, parts of Dave's collected advice is called the Seven Baby Steps.

0. Stop overspending and get current with all creditors.
(not part of the official steps, but a necessary precursor)
1. Save $1000 to *start* an emergency fund
2. Pay off all debt (except the house) using the “Debt Snowball,” paying off the SMALLEST debt first
3. Save 3 – 6 months of expenses for a full emergency fund
4. Invest 15% of your household income into Roth IRAs and pre-tax retirement
5. Save college funding for children
6. Pay off your home early
7. Build your wealth and give

He calls them baby steps, but by the time you're at step 7, you're there, right?  Financial Peace.


What's this got to do with Affordable Homes?

Now to paraphrase some bits of Dave's advice (from a variety of sources) as it relates to affordable homes....

Eliminate Debt First

Before you even think of buying a house, eliminate your other debt.  First, pay off your credit cards, pay off your student loans, pay off your car.

Debt Word Cloud courtesy of www.vectorportal.com

100% Cash Downpayment

Buy your home for cash.  Save up until you can afford to do that.
What?  Who does this?  I find it to be a bit absurd, but only because homes are so stinking expensive.

Or Get an "Affordable" Mortgage

Image courtesy of 401(k) 2012
If you MUST have a mortgage, only get a payment you can really afford.
Be conservative with terms:  Get a 15 year fixed rate mortgage.  Never a 30 or 40 year, never an ARM or a balloon mortgage.
Remember that banks are in business to get money from you.  Do not take their advice on how much debt you can bear.
For the path to Financial Peace, Dave says that what's AFFORDABLE is a mortgage payment that is less than 25% of your NET* monthly income.

  • * Banks often recommend 28% of your GROSS income just for the mortgage (called "front end") or 36% total of your gross income for the mortgage plus any other credit payments (called "back end").
  •   31% back end is the definition of "affordable" from the U.S. "Making Home Affordable" program.
  •   The FHA back end max is 41%.  
  •   Dave's "back end and "front end" are the same thing, since you are not buying a home until you've paid off your other debt.



The above percentages give vastly different answers as to what is supposedly affordable.  Remember that the banks are allowing you to borrow as much as they dare.
What happens if you apply for and are "awarded" (!!) a payment that is twice what you can actually afford?  Exactly.


If you have a mortgage, pay it off early (Baby Step 6). 

Image courtesy of 401(k) 2012

Don't pay out interest you don't have to pay out simply because that interest is a tax write-off.  Do not get a 2nd mortgage or a home equity loan... that's going in the wrong direction (towards more debt).
Mr. Ramsey has a mortgage payoff calculator on his website to help you figure out how to pay your mortgage off early and reduce the financial hemorrhage.


Now go out and find an Affordable Home

"Pies" in upstate NY
courtesy of basykes

Seems simple, right?  All you have to do now is find a home that meets the financial criteria and is a great home in a neighborhood with great schools or nightlife or farmers' markets or whatever you're into.

Easy as pie; but who thinks pie is easy?

ally


Update 7/16/2015: Tenants in England Spend Half Their Pay on Rent
Also, section above on the Affordability Ratio added.

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