In the last article I analyzed homeownership affordability in the last decade and compared US affordability data to the rest of world. This article takes a deeper dive by examining a home purchase decision through the lens of a FIRE-seeker vs. Conventional path. Focusing on which ratio is best when determining your borrowing limit.
Let’s analyze two paths using the average household income in America ($83,886). When applying for a mortgage, your lender will attempt to qualify you based on ratios. One of these is the Mortgage to Income ratio of 28%. Under this ratio your total mortgage payment cannot exceed 28% of gross monthly income (before tax, health insurance, retirement or other payroll deductions).
In the FI community there is another more conservative ratio. Your mortgage payment should be no more than 25% of your net monthly income (to your bank account). Let’s apply these ratios to the average household income and review what someone qualifies for with each.
Conventional Ratio: 28% (gross income)
(28% * ($83,866/12)) = $1957/mo.
With a 5% down payment, you can buy a 362k house under this ratio.
FI-Seeker Ratio: 25% (net income)
(25% * (($83,866/12) * 75%)) = $1310/mo.
Assuming the same down payment as the more expensive home ($18,100), you can buy a 246k house.
Find Your Ratio
With the conventional 28% ratio you can afford a home that is 50% more expensive. What is going on here?
After reviewing paystubs, I found that my net pay is about 75% of my gross. This 25% withholding is FICA tax, family medical insurance premiums, dental insurance premiums and retirement contributions. I recommend you review your most recent paystub to find your net pay percentage. Ask yourself:
- Are you contributing your goal retirement percentage?
- Do you receive a sizable tax refund?
- Can you reduce federal tax withholding and increase your retirement contribution percentage?
Improve Your Ratio
When you see 25% net ratio price of 246k do you think, “there’s nothing I’d want to buy for anything near that price in my area.” That might be true. To tilt the ratios, you have a few levers to pull:
- Increase your income – even a $500/mo. side hustle income permits a price of 282k under the 25% conservative rule. Be so essential at work that you can ask for a pay increase or find a higher paying job through new skill development
- Increase your down payment – doubling your down payment to $36,200 permits a purchase price of 273k. A tougher path to lower the monthly payment, but this is a lever.
- Buy a fixer upper –find a house in need of cosmetic improvements (paint, flooring, fixtures, landscaping). I stress cosmetic because you can easily bite off more than intended. Especially if the house is in poor condition or so far outside your desired layout it requires significant remodeling. You can unintentionally evade the purpose of the ratios – preventing a crippling, fixed housing expense.
Household Expenses and the 28% Conventional Ratio
(this analysis applies other household expense estimates based on my family of four to the average household income – $83,866)
Why use the 25% net ratio when the bank qualifies at 28% of gross?
Based off gross income, the bank does not factor in your retirement contributions. If buying a home makes you unable to contribute to retirement or only able to at a small percentage (under 5%), your journey to FI will be a long one.
With normal household expenses, the 28% Conventional ratio stretches your budget too thin:
- $563/mo. (Debt and Stress – FI Chronicles) Car payment = 8% of gross (that’s just one car!)
- $1500/mo. Food budget (my estimate based on a family of 4 with limited dining out) = 22% of gross
- $450/mo. five basic utility expenses (water, electric, auto insurance, internet, cell phone), optimized:
- shopping electricity contracts every 2 years
- annual auto insurance quotes
- annual internet package comparison
- discount pre-paid wireless – Mint mobile
- ditching cable
Basic utility costs = 7% of gross
The expenses total 90% of average household income:
- 25% in payroll deductions (FICA, insurance premiums, retirement contributions)
- 28% Conventional Rule mortgage payment
- 37% car, food, five basic utilities
This leaves 10% remaining for giving, travel, entertainment, discretionary and life’s curveballs (flat tires, new roofs, AC units etc.). A 10% margin is not enough for all this, causing many American families financial struggle.
Maybe month after month no unexpected expenses come up? I’m not sure about your life, but for mine, that’s not the case. And it’s multiplied when you add in more variables – like kids.
- Review your last paystub to find your net pay percentage.
- Decide if your retirement contribution is adequate. Increase, if possible, by adjusting other payroll variables like tax withholding.
- If you’re a homeowner, determine your current housing percentage of net pay. And if contemplating a buy, use a payment calculator tool to see how much home you can afford under the 28% Conventional and 25% FI-seeker ratios.
- Categorize monthly expenses to learn your major fixed costs (transportation, food, utilities). See our budgeting method in detail for guidance.
Which ratio is best? We have decisions to make in life. Sometimes these are small decisions and sometimes they are trajectory-altering. How much home you buy is a trajectory-altering decision. Take the time to determine your goals and analyze this decision to ensure the home helps and doesn’t slow you down.