Updated for 2013. By definition, a “rule of thumb” is meant to be a greatly simplified estimate for a complicated matter. Mortgage lenders use income size, income stability, credit score, downpayment size, and other factors before approving a loan. But the most common way to express affordability is as a multiple of your household or individual annual income. CNN Money says 2.5 times:
The rule of thumb here is to aim for a home that costs about two-and-a-half times your gross annual salary.
The now-defunct Washington Mutual Bank suggested up to 4-5 times:
As a broad generalization, most people can afford to purchase a house worth about three times their total (gross) annual income, assuming a 20% down payment and a moderate amount of other long-term debts, such as car or student loan payments. With no other debts, you can probably afford a house worth up to four or even five times your annual income.
Running Your Own Numbers
I decided to run some numbers for myself using values I think are reasonable along with current interest rates. The Federal Housing Administration provides the following guidelines for the loans that they accept:
- The front-end debt-to-income ratio – mortgage payment (PITI) divided by gross income – should be less than 31%.
- The back-end debt-to-income ratio – mortgage payment plus all recurring monthly debt, all divided by gross income – should be less than 43%.
Here are some other quick and dirty assumptions based on the average US household:
- US Median household income is around $50,000 gross a year, or $4,200 a month.
- Taxes and homeowner’s insurance. CNN reports the national averages to be $3,500 for annual property taxes and $481 for annual homeowner’s insurance premiums. Together that’s $330 a month.
- Credit card debt. The Federal Reserve reports the average household credit card debt to be about $7,000. The underwriting guidelines use minimum payments, so if you assume a 3% minimum payment that’s $210 a month.
- Car loans. Experian reports that the average monthly loan payments was $452 for new cars and $351 for used cars (source). Let’s use $400 for this exercise and assume one new car per household.
- Current 30-year fixed mortgage rate is about 4.25%.
20% Down Payment, 31% Front-End Ratio
Using a 31% front-end ratio, that means PITI (principal + interest + taxes + insurance) can be $1,300 a month. Taking out $330 for taxes and homeowner’s insurance, that leaves us $970 a month for principal and interest. With a 20% downpayment and a 4.25% interest rate, that works out to roughly a $198,000 maximum loan size and $248,000 maximum total home price = 5 times gross income.
20% Down Payment, 43% Back-End Ratio
Using a 43% back-end ratio and the average consumer debt numbers from above, we start with $1,806 and take out $330 for taxes and HO insurance, $210 for credit card payments, $400 for car payments. That leaves us with $866 for the mortgage payment at 4.25%. The resulting $176,000 max loan size with 20% down payment gives a $220,000 total home price = 4.4 times gross income.
5% Down Payment, 31% Front-End Ratio
The minimum down payment amount for a FHA loan is actually only 3.5%, but you will be subject to additional mortgage insurance of ~1.25% of the loan amount annually. Having to pay PMI means less money available to go towards the loan, so our numbers now only give us a $163,000 max loan size. With a 5% down payment, that means a total home price of $171,000 = 4.4 times gross income.
5% Down Payment, 43% Back-End Ratio
Doing the same calculation using the 43% back-end ratio which takes into account other consumer debt payments, you end up with only roughly $146,000 max loan size and loan and total home price of $154,000 = 3.1 times gross income.
As you can see, even trying to create a simple rule of thumb becomes very difficult due to all the potential variables out there. However, 3 to 5 times gross income does turn out to be a reasonable place to start. More importantly, hopefully this example will help you run some numbers on your own. As always, just because someone is willing to lend you a certain amount, doesn’t mean you have to take it!