Inside a post about what economists think about buying vs. renting a house, Alex Tabarrok of Marginal Revolution ended with a nice sentence that I think applies to both buying and renting:

One final point: behavioral economics tells us that we quickly get used to big houses but we never get used to commuting. So when you have a choice, go for the smaller house closer to work.

In general, our current choice of house is aligned with this advice. We could get a bigger, newer, and/or cheaper house in exchange for a longer commute, but are happy with our size (2,000 square feet) and location (I work primarily from home and my wife’s distance to work is 3.5 miles). Our jobs are relatively stable, however, as jumping to a new job could easily change our commute.

Going for the shorter commute over the bigger house certainly feels like good advice. But what are the behavorial economics studies that support this statement?

First, let’s take the statement we get used to big houses. The overall concept of the hedonic treadmill has been found in a variety of circumstances. Brickman, Coates, and Janoff-Bulman (1978) found that lottery winners and paraplegics eventually returned to their baseline happiness levels over time. That is, both the joy of winning the lottery and the sadness from being paralyzed was not permanent. Per Wikipedia, Lucas, Clark, Georgellis, & Diener (2006) also “ultimately concluded that people completely adapt, return to their baseline level of well-being, after divorce, losing a spouse, birth of a child, and females losing their job.”

However, but I couldn’t find one that studied housing specifically. There’s probably one out there? Perhaps a bigger house can simply be lumped in with other consumer material goods.

Second, if we can get used to being paralyzed or losing a spouse, who says that we don’t get used to commuting? Perhaps this is taken from Stress That Doesn’t Pay: The Commuting Paradox (Stutzer and Frey, 2004). Abstract (emphasis mine):

People spend a lot of time commuting and often find it a burden. According to economics, the burden of commuting is chosen when compensated either on the labor or on the housing market so that individuals’ utility is equalized. However, in a direct test of this strong notion of equilibrium, we find that people with longer commuting time report systematically lower subjective well-being. Additional empirical analyses do not find institutional explanations of the empirical results that commuters systematically incur losses. We discuss several possibilities of an extended model of human behavior able to explain this ‘commuting paradox’.

If you know of more please let me know in the comments.

As a parent of young children, the following chart from this CityLab article definitely caught my attention:

The trend is clear that as time goes on, more and more people are living with their parents. At what point does it start being called living with your children? For the purposes of this chart, is child living with a parent (suggesting parent is head-of-household) different from a parent living with a child (suggesting that child is head-of-household)? I think so. Otherwise, you’d think there would be a bump at ages past 65.

The article speculates the eventual effect on housing:

Jordan Rappaport, a senior economist for the Kansas City Fed, uses these figures to explain the transformation in the multifamily housing market over the past 30 years. Rappaport’s paper explains that, in the short term, young adults are driving the market for new multifamily housing construction. Over the long term, however, retiring Baby Boomers will drive multifamily housing construction as they downsize. […]

As Baby Boomers begin to retire and downsize, they will drive the construction of new multifamily housing. What that means, we don’t fully know yet. This new construction might not look much like the condos and apartments that developers are building today in order to chase young-adult households. It also might not look like the downsizing options preferred by seniors in the past.

I agree that the overall economic trend is going to be more multi-generational housing. It’s just cheaper. Housing costs eat up a huge chunk of income, and sharing housing can reduce overall costs for both parties involved. As quoted in my previous post Economics of Shared Living: Estimated Savings From Having Roommates, Scott Burns notes that “Cooperation is a wonderful but generally overlooked substitute for money.”

In places where land is quite expensive like California and Hawaii, “in-law” or “ohana” units are quite popular. The official term is “accessory dwelling unit”, or ADU, where separate living quarters are created on what was previously a singly-family home. This could either be a detached studio or the converted wing of the original house with a kitchenette to add privacy and separation. Your parents could live there, or your adult kid could live there, often both.

Often, these are only legal if you have a direct relative living in them. However, new legislation has been introduced in many areas to make these legal rental units. In San Francisco, you can now apply to legalize your un-permited unit. In Honolulu, a bill to legalize ADUs of up to 800 square feet was just signed into law. Basically you can now add a little, legal rental on the side of your house.

I think these shared-but-separate living situations will start popping up more and more in the rest of the United States. Many new home designs now include such units from the very beginning. It is a way of creating more affordable housing for renters and additional income for homeowners.

Updated. Buying a house is always an exciting yet terrifying time. Deciding on how much we can “afford” is often limited by how much someone will lend us. Mortgage lenders use income size, income stability, credit score, down payment size, and other factors before approving a loan. Let’s explore the idea of a “rule of thumb” to greatly simplify such a complicated matter. 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 is to aim for a home that costs about two-and-a-half times your gross annual salary. If you have significant credit card debt or other financial obligations like alimony or even an expensive hobby, then you may need to set your sights lower.

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.

Investopedia offers up 2 to 2.5 times:

Generally speaking, most prospective homeowners can afford to mortgage a property that costs between 2 and 2.5 times their gross income.

Running Your Own Numbers

Where do these numbers above come from? Most government-backed mortgages utilize the following ratios for their underwriting:

• Front-end debt-to-income ratio = housing-related costs (PITI) divided by gross income. PITI stands for principal, interest, taxes, and insurance.
• Back-end debt-to-income ratio = housing-related costs (PITI) plus all recurring monthly debt, all divided by gross income. Recurring monthly debt includes student loans, car loans, credit card debt, and alimony/child-support obligations.

Essentially, they want to be sure that housing costs don’t take over your entire budget and also that you can still handle your total monthly debt load. (Left out are things like food, transportation, other insurance, health care, etc.) Each of the major lending agencies has their own set of DTI limits, but let’s use the standard Federal Housing Administration (FHA) limits of 31% for front-end DTI and 43% for back-end DTI.

You can insert your own numbers here, but let’s use these statistics based on the average US household:

• Household income. Government statistics have the median US household earning around $52,000 gross a year, or $4,300 a month.
• Taxes and homeowner’s insurance. Depending on the survey, the national average is somewhere between $2,000 and $3,000 for annual property taxes and roughly $1,000 for annual homeowner’s insurance premiums. Together that’s roughly $300 a month.
• Credit card debt. The Federal Reserve reports the average household credit card debt to be about $7,500. The underwriting guidelines use minimum payments, so if you assume a 3% minimum payment that’s $225 a month.
• Car loans. Experian reports that the average monthly loan payments was $450 for new cars and $350 for used cars. Let’s use $400 for this exercise and assume one new car per household.
• Student loans. For households with student debt, Brookings estimates that the average monthly payment is $240.
• Current 30-year fixed mortgage rate. Bankrate and HSH report this to be about 4.25%.  You can always refinance your mortgage to lower your rate as well.

20% Down Payment, 31% Front-End Ratio
Using a 31% front-end ratio, that means PITI (principal + interest + taxes + insurance) can be $1,333 a month. Taking out $300 for taxes and homeowner’s insurance, that leaves us $1,033 a month for principal and interest. With a 20% down payment and a 4.25% interest rate, that works out to roughly a $210,000 maximum loan size and $260,000 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 $1,850 and take out $300 for taxes and HO insurance, $225 for credit card payments, $400 for car payments, $240 for student loans. That leaves us with $685 for the mortgage payment at 4.25%. The resulting $140,000 max loan size with 20% down payment gives a $175,000 total home price = 3.4 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 Upfront Mortgage Insurance Premium (UFMIP) of 1.35% of the loan amount plus an ongoing PMI of 0.80-0.85% of the loan amount annually based on your loan-to-value ratio. Having to pay PMI means less money available to go towards the loan, so our numbers now only give us a $185,000 max loan size. With a 5% down payment, that means a total home price of $195,000 = 3.75 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 debt payments, you end up with only roughly $110,000 max loan size and loan and total home price of $117,000 = 2.25 times gross income.

By doing this exercise, we see that someone with a car note, credit card debt, and student loans is certainly going to have a much different measure of affordability than someone without such pre-existing obligations. Perhaps there is no easy rule of thumb? If I had to, I would say that a household with “significant” debt could start at 2x income, while someone with very little debt could start with 3x income. But it shouldn’t be too difficult to use this example to get much more accurate numbers.

Most importantly, just because someone is willing to lend you a certain amount, doesn’t mean you have to take it! Here are some posts that may help you get the most value for your housing dollar:

• Size of house? How many square feet do you really need? and Increase in Housing Quality vs. Increase in Housing Prices
• Shorter commute and smaller/more expensive, or longer commute and bigger/cheaper house? Housing Search Trade-Off: Price vs. Commute Time and Expert Says: Biggest Waste of Time is Commuting
• Moving to a different city? Roundup of Top 10 Best Cities Listsand What cities are people actually moving to?

Businessweek magazine celebrated their 85th anniversary by listing what they deem the 85 inventions with the greatest impact over the last 85 years. #1 was jet engines, but #17 was the fixed-rate mortgage.

At the time, it was bold and controversial decision done in response to the Great Depression. The government wanted a way to refinance home mortgages currently in default to prevent foreclosure:

In 1933, to provide stability, the now-extinct Home Owners’ Loan Corp. introduced a new type of mortgage: It had a fixed rate and was fully amortized, meaning borrowers paid off the entire loan by the end of the term. Not everyone cheered. Critics railed that it was “crazy and un-American [to be] putting people in debt for 15 years,” says Louis Hyman, author of Debtor Nation: The History of America in Red Ink.

That last quote suggests that a 15-year mortgage was really long and people used to pay off their mortgages a lot faster. I’m not really sure if that was the case, or if there was just a big split between people who could pay cash for a house and those that couldn’t. Wikipedia states that the previous standard in the 1920s was either 3-5 year interest-only mortgages offered by commercial banks or 10-12 year loans which required buying shares in the lender itself (not good when the share value plummets in an economic crisis).

If you think about it, fixed-rate mortgage are pretty reasonable terms. A fixed payment every month evenly spread out over 30 years, and as long as you don’t miss any payments you’ll be fully paid off by the end of the loan period. It kind of makes you wonder if private companies would have created such an instrument in the “free market” absent government intervention. Of course, you have to wonder what would housing prices be like without their existence? (Just today I see that Fannie and Freddie announced the backing of 3% downpayment mortgages.)

Since they do exist, I still think people should use them to time their mortgage payoff with their retirement date. For many people, a 30-year fixed rate mortgage will do just that if they don’t refinance into a longer term. Start at age 30-something, finish at 60-something. For those that are serious about early retirement, then the 15-year mortgage may be a better fit.