When you go to the bank to look at getting a mortgage pre-approval, they will often quote you a ridiculous figure as the maximum amount you can borrow. This number is usually based on a simple metric, such as “debt payments should be no more than 40% of income”. Such simple metrics can lead to people borrowing excessively, and getting in over their heads. In this age of guaranteed mortgages and bank bailouts, however, the banks aren’t incentivized to manage their risk appropriately, so why wouldn’t they increase their profits by encouraging people to borrow more?
When considering what is an appropriate amount to borrow, remember: what’s in the bank’s best interest is not necessarily what’s in your best interest.
Simple rules for determining how much you should spend
One common metric of housing affordability is to compare median home prices to median income; if this ratio is around 3 or below, then housing can be considered affordable. This can be extrapolated to a personal evaluation: If our combined income is $100,000 a year, then the maximum we should spend on a home is $300,000.
While this isn’t a bad rule to follow, it skips over some important details. I personally prefer the following rule: Spend no more than 33% of your net income on total home carrying costs. I look at net income, because tax levels and deductions vary from person to person and place to place. I also look at the total home carrying costs, because the property price and the mortgage alone don’t tell the whole story.
Let’s look at a newlywed couple, Wynona and Karl, who just walked into the bank and were told they could spend up to $450,000 on a new place, including a 20% downpayment. Ecstatic that they qualify for such a large loan, they immediately start hunting for a new place in an upscale area downtown…
Our couple looks for a new place to live…
Imagine our couple took advantage of the bank’s maximum loan amount and bought a nice condo in the heart of downtown:
- $450,000 purchase price; 20% down, 2.5% mortgage rate.
- $6,000/yr. property taxes.
- $350/mo. condo fees.
The ratio of this home’s total carrying costs to this couple’s net income is almost 50%. This is bad for a few reasons:
- After additional spending on transportation, food, clothes, and other everyday expenses, there isn’t that much left to go toward our couple’s savings, childrens’ education, retirement, etc….
- It’s impossible for one person to stop working for a long period of time. With such a high cost of living, if someone loses their job, even with unemployment insurance our couple is looking at 75% or more of net income going toward just the upkeep of their home. This is an incredibly stressful situation to be in. Should there be a significant economic downturn, this couple might be forced to sell or foreclose, and at a large loss.
Taking the maximum bank loan places one in too precarious of a situation. I recommend instead that one add up all of the expenses, and aim to spend no more than 33% of net income on their total home carrying costs.
Let’s look at another home; this one is still fairly nice, though not in the heart of downtown:
- $300,000 purchase price; 20% down, 2.5% mortgage rate.
- $4,000/yr. property taxes.
- $220/mo. condo fees.
The picture already looks much better. By reducing overall expenses by one-third, the ratio has been reduced from almost 50% down to 33%. This is around the maximum I would recommend spending on a home in today’s environment, since it offers a lot more breathing space. This extra room brings additional security, especially should the economy dip back down or should interest rates rise.
The important thing to keep in mind here is that the mortgage is just one component of overall housing costs. Two properties at similar price points can nonetheless have very different overall costs. Here’s an example of two units; one happens to be one of the best units of an inner-suburban condo complex, and the other happens to be one of the worst units of a downtown condo complex:
There’s not really much difference between these two units (the downtown one is slightly more expensive as the indoor parking is more expensive), but when you add up all of the expenses (especially the property taxes), it actually makes a significant difference in the end.
There is also a qualitative difference: I personally would rather live in a nice unit in a middle-class building, than have one of the crappiest units in a building full of rich people. It’s just not the same feeling at all. If you live in a building where most people are wealthier than you, you also run the risk of paying much larger fees than you are comfortable with, down the road. It’s not unheard of for condo fees in these types of buildings to double (!) within the span of a few years.
Investing it wisely
- Life is unpredictable, and one never knows when the next economic downturn will come or when the next round of layoffs will happen. Keep a healthy gap between income and expenses, and spend no more than 33% of your net income on total home carrying costs. You want to be able to save money and have money left over for other goals.
- Interest rates are still at historic lows. While one cannot predict when they will rise, there is more downside risk of rates rising than there is upside risk of rates going down to 0%. Take into consideration a rise in rates of 2%-3% when planning your budget.
So, reader, what are your own considerations when looking for a new place to live? I’d love to hear your thoughts.