I found this article explaining the ratios using a 7% interest rate. It used to be that you should only use 28% of your gross income for a mortgage with 36% as a maximum. I guess our new paradigm of lending changed all that at least for the first couple of years of the mortgage. There is a awful lot of pain out there right now.
“If we do take this as an assumption and apply what most lenders call affordable (paying a maximum of 28% of your monthly income for your mortgage), we can figure out what medium home price to medium family income ratio is for a given down payment and mortgage interest rate. What we have then is a number that represents the maximum multiple of income that a home could cost and still be affordable (again by the conventional definition of affordability) to a medium income earner. Given the assumption above, this ratio is valid across the entire US housing market and allows us to directly compare one market to another (assuming, of course, we are using local values for median family income and median home price).
To figure out what the maximum affordable home price to income ratio is, let’s assume we earn a medium family income of $1000 a year (we can assume anything and it will not change the ratio). Again, lending standards say that we can use a maximum 28% of our monthly income to service our home mortgage debt. So we have (1000/12)*.28=23.33 dollars available each month that we can use to pay the mortgage. Now we need to figure out the monthly cost for each $1000 we borrow so that we can know how much we can spend on a home. For a 7% fixed rate 30 year loan (for example), it costs $6.65 a month to borrow 1000 dollars. Therefore we can afford to borrow 23.33/6.65=3.5 multiples of 1000 dollars (i.e. 3.5*1000=3500 dollars). 3.5 is then the maximum affordable medium home price to medium family income ratio for a mortgage with 0 dollars down and a fixed 7% interest rate. Said in a more realistic way, a family making $100,000 a year can afford at most a $350,000 home (350000/100000=3.5) with this mortgage.
For rates of 6% and 8% (all other conditions the same) the ratios are 3.9 and 3.2 respectively. The ratio is larger for smaller interest rates because the cost of borrowing money is cheaper and we can do more with the 28% of our income we are allowed to use. Again, these ratios hold true for any locale given our assumptions.”
