Jan. 12, 2009 -- So is it time to buy a house? Has the market bottomed out?
Home values declined more than 16 percent from 2007 to 2008, according to the S&P Case-Shiller Home Price national index, which compared the third quarter of each year. And while that is upsetting news for homeowners, it could be very welcome news to those who were shut out of the American Dream because prices were too high.
I am neither a market analyst nor a fortune teller. I can't tell you whether today's prices are fair. But as a consumer reporter, I can tell you how to figure out what you can afford. The question of whether you're ready to buy is so simple -- and yet so complicated -- that it makes my head spin as I sit here trying to write about it. I'm going to give you the simple version.
The first consideration is how long you plan to own the home. Say you do well and buy it at precisely its current value. On top of that, you have to pay closing costs. So, of course, if you sell the home two years later for the same price you paid, you have actually lost money.
You really want to keep the home long enough for it to appreciate to the point that you make a profit that covers those closing costs. (The other key is to keep your closing costs down in the first place and I talked about that in a previous column.)
I'm going to go out on a limb here and just pick a number. I don't think you should buy unless you plan to stay in the place for at least seven years. Lucky seven.
In the current economic climate, it's quite possible property values will go down some more. What if I'm wrong and, after seven years, you still haven't recouped your closing costs? If you really need to move, you could just kiss them off. After all, when you rent you give away your money month after month anyway. But there's also a simple strategy some people used after real estate values went down for a time in the 1980s.
Remember Income Tax Benefits
It's a no-brainer: rent the place out for a few years to give it more time to appreciate. I rented from a woman in that situation once. There are two disadvantages to that plan. One, being a landlord is often a nasty experience. Two, your money will be tied up in the property, making it harder to buy another place for yourself. On the other hand, some people who were forced into this situation ended up becoming mini real estate barons because they scrimped and managed to keep their rental place and buy a place for themselves -- and then buy more.
But back to the present. To figure out what size monthly housing payment you can afford, you could use an online calculator, but I think many of them are designed by people who want to sell mortgages and may overstate what you can afford. So instead (or in addition), I say start with your rent. Let's assume you make your monthly rent payments without any strain. You'll actually be able to afford a higher payment when you own because of the income tax benefits.
I'm going to give you a grossly over-simplified formula that will give you a rough idea. Let's say you pay $1,000 in rent each month and your top income tax rate is 20 percent. Take your rent and divide it by the other 80 percent to determine an affordable monthly housing payment: 1,000 divided by 0.80 equals $1,250. Or, your rent divided by the percentage of your income that remains after taxes = X.
That's about how much you can afford to pay for housing when you own the place. It's not a perfect formula because you're not allowed to deduct your entire mortgage payment from your taxes. Only the interest is deductible. Then again, in the beginning of a mortgage loan, most of your payment does go to interest, so it's a reasonable calculation.
Now remember, that amount has to cover the mortgage itself plus property taxes, homeowner's insurance and homeowner's association fees, if any. You should also set aside money for maintenance because there won't be a landlord to fix things anymore. Keep in mind your utility bills could also be higher if you're buying a bigger place than you rent. (You can find out how much the home's monthly power bills are by calling the power company.)
Purple Walls? Go for It
In order to have access to the cash for your new, higher housing payments, you will need to reduce the amount of income tax that is withheld from your paychecks. Ask a tax accountant how many additional allowances you should claim on your W-4 form.
So that's an idea of what size mortgage you can afford. Now you need to know what size mortgage you're likely to get. During the real estate bubble, who knows what formula -- if any -- lenders were using to determine people's eligibility. But now lenders are back to using an old rule of thumb called the 28 percent and 36 percent rule.
They say that your total monthly housing costs (mortgage, property taxes and homeowner's insurance) should be no more than 28 percent of your gross monthly income. They calculate that your total housing costs plus long term debt (alimony, car loans, student loans, etc.) should be no more than 36 percent of your gross monthly income. The strictest lenders make you meet both these standards and sometimes use even lower percentages.
One final thought: all these formulas and numbers are important but also keep in mind that real estate is different from other investments. If the numbers look pretty good for you to buy but you are still on the fence, remember that it is not just a house, it's a home. A place where you can paint the walls purple if you want. A place where your kids can build forts. A place of your own.