Apr292013

Renter’s guide to preparing for home ownership

I have been accused of being “old school” because I never embraced the innovations in real estate finance that inflated the housing bubble. In 2006 preparing for home ownership only required finding a house and signing a few loan documents. It’s a lot more difficult today.

Now the old rules are back. Buyers today have to save for a down payment and make sure the payments are affordable. Since so many forgot the old ways, I felt it necessary to revisit these old methods to educate the next generation — and perhaps reeducate the old one.

Adjusting your finances

People can adjust to whatever income and expenses they have if given a little time. Transitioning from renting to home ownership shouldn’t be a difficult adjustment if you follow a few simple guidelines for structuring your finances while you’re still renting. To make the adjustment, you need to carefully budget for saving for a down payment and making the house payment once you purchase. Fortunately, this is not as difficult as some imagine.

PITI

The first task is to figure out how much you will have to spend each month when you own your home. Lenders don’t pity borrowers, but they are very concerned with an acronym called PITI. It is a formula they use to calculate the maximum monthly payment you can afford. PITI is short for principal, interest, taxes and insurance, but it also includes other known costs such as HOA dues and private mortgage insurance. When a lender calculates the maximum loan they will extend a borrower to buy a particular property, they start with the borrowers income and apply the maximum debt-to-income ratio, currently 31%. They take this number and divide it by 12 to come up with a maximum PITI.

For example, let’s say a borrower making $100,000 per year wants to buy a home. The lender will allow them to put $31,000 per year ($100,000 x 0.31) or $2,583 per month to cover PITI. This number is very important because it tells you how much you can expect to write checks for each month if you max out your loan (most do) to buy a home.

Maximum loan balance

When lenders calculate your maximum allowable loan balance, they back out taxes (including Mello Roos), insurance, and HOA dues to calculate the remaining amount left over to cover the payment, which includes principal and interest. Generally, about 25% of PITI is consumed by taxes, insurance and other costs. Let’s assume $583 is consumed for these backed-out items. The remaining $2,000 is available to make a payment. From that, lenders use another formula that takes into account the interest rate to calculate the maximum loan balance.

If we stay with our example from above, a borrower making $100,000 per year making a $2,000 monthly payment can borrow $440,000 using 20% down conventional financing or $381,175 using FHA financing. The difference is caused by the lower payment due to the cost of FHA insurance.

For those of you who are interested, this formula is the present value formula. The following computes the maximum loan over a term of n months at a monthly interest rate of c. [If the quoted rate is 6%, for example, c is .06/12 or .005]. 360 periods is used.

Maximum Loan Balance = Payment × [(1 – (1 + c)-n) ÷ c]. The present value formula for Microsoft Excel is as follows:

P = PV(c, n, Payment)

Don’t worry, the lender will do this math for you.

Rent and Savings

As a renter hoping to buy, you must adjust your lifestyle to fit within your PITI amount. Your current rent should be far enough below this figure to allow you to save money for your down payment. But how much below? What is a good guideline for determining the maximum rent you should be paying each month? This is an important question because if you base your selection of a rental based on the PITI of your ultimate cost of ownership, you will also become accustomed to living in the quality of home you will ultimately afford to purchase. Fortunately, there is a formula to figure this out.

I’ve run the cost of ownership calculations on thousands of properties. The monthly cost of ownership is generally 25% to 30% below PITI. This monthly cost of ownership relates to rental parity, the foundation of housing market values.

If you use that guideline, a renter making $100,000 a year should be paying about $1,900 in rent and saving about $700 per month toward a down payment. That translates to a 23% rent-to-income ratio. Anyone with the discipline to live this way will be able to save for a down payment and comfortably transition to home ownership. Anyone who doesn’t have the discipline to live this way may not be cut out for home ownership.

From the above example, a $440,000 conventional loan balance leaves a $110,000 down payment to purchase a $550,000 house. Notice that 3.6% interest rates allow borrowers to purchase at price-to-income ratios of 5.5. That’s very high by historic standards.

At $700 per month, it will take 158 months to save the $142,052 for a down payment. Thirteen years is a very long time. That’s why so many people opt for FHA financing with 3.5% down. At $700 per month, it only takes 20 months, or just over a year and a half, to save the $13,825 required to cover the FHA down payment on a $395,000 property.

Did you notice the catch to using FHA financing? People who don’t have a 20% down payment have to settle for much less house on the same income. This is why the tradition of buying a starter home, waiting until it accrues 20% equity, then selling for a move-up is such a big part of our housing market.

Interest rates and the rent-save ratio

The guideline I describe above, spending 23% of gross income on rent and saving 8% is based on our current 3.5% interest rate. This mirrors the ratio of interest and principal repayment within the loan payment. At low rates, prices are inflated, and more must be put toward savings to acquire a down payment. Fortunately, at very low interest rates, more of the payment goes toward principal than at higher rates. At 10% interest rates, a rent-save ratio of 28% toward rent and 3% toward savings will yield the same results. At higher interest rates, less of a monthly payment goes toward the principal repayment and more goes toward interest. Fortunately, at high interest rates, prices are not inflated, and it takes less savings to close the deal.

If we do see higher interest rates, which we ultimately will, part of the reason for pricing pressure on houses comes from the lower amount of financing, but another pressure is the down payment barrier. It’s very hard for most people to save in a high interest rate environment. With higher interest rates, their savings grow faster, but potential buyers also pay more interest on car loans, student loans, and credit cards.

The bottom line

To prepare for home ownership, rent a property using 23% or less of your gross income. Save 8% of your gross income in a special down payment account you don’t raid for other lifestyle expenses or purchases. In less than two years, you will have the down payment to purchase a property comparable to your rental using FHA financing. With the discipline you gained from living within your means and saving for a down payment, you will succeed as a home owner and build equity through paying down a mortgage. You might even be rewarded by the appreciation fairies and complete a move-up once you have about 30% equity in your home and you can sell, cover the closing costs and still have 20% for a down payment on a nicer property.