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.
| Net income | $5,500 |
| Mortgage | -$1,612 |
| Property taxes | -$500 |
| Insurance | -$80 |
| Heating/electricity | -$80 |
| Condo fees | -$350 |
| Maintenance | -$50 |
| Total | -$2,672 |
| Remaining income | $2,828 |
| Ratio | 49% |
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.
| Net income | $5,500 |
| Mortgage | -$1,075 |
| Property taxes | -$333 |
| Insurance | -$80 |
| Heating/electricity | -$60 |
| Condo fees | -$220 |
| Maintenance | -$50 |
| Total | -$1,818 |
| Remaining income | $3,682 |
| Ratio: | 33% |
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:
Inner-suburban unit
| Net income | $5,500 |
| Mortgage | -$1,120 |
| Property taxes | -$300 |
| Insurance | -$80 |
| Heating/electricity | -$60 |
| Condo fees | -$220 |
| Maintenance | -$50 |
| Total | -$1,830 |
| Remaining income | $3,670 |
| Ratio: | 33% |
Downtown unit
| Net income | $5,500 |
| Mortgage | -$1,250 |
| Property taxes | -$500 |
| Insurance | -$80 |
| Heating/electricity | -$60 |
| Condo fees | -$300 |
| Maintenance | -$50 |
| Total | -$2,240 |
| Remaining income | $3,260 |
| Ratio: | 41% |
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.
I like the 33% ratio you gave. That is pretty much what we spend on our housing costs and it works just fine. We are able to save a bit every year and have a nice house that we enjoy. I think you enjoy it even more when you know it doesn’t get you in trouble! But, I would recommend also to look at the total budget situation before buying a house. Some persons/couples have very expensive other costs not related to the house (transportation, parking, any sort of sports, cars, debts) that must be thinking about before buying a house.
Yep, that is a very good point. That’s also why I recommend that there be a healthy gap between expenses and income (if you can manage to get everything in 50% or less, that is pretty good IMO. I don’t think we are there yet but hopefully can get there soon).
Great post, as always.
Believe it or not, here in Canada i’ve read that banks often give up to 125% of what a person can afford according to their household to debt ratio. Insane.
We would do well to not accept the “free candy” being handed out by the bank… high debt loads for consumer spending (and a home, in the end, is a consumer durable) are good for the bank, but not great for the debtor!
Preparing for the worst is so important when planning for a home purchase. Can’t stress enough on the point ‘keep a healthy gap between income and expenses’.
Great post Kevin!
Thanks! I believe achieving and maintaining this gap is more important than an emergency fund even, since if you have more income, replenishing your stores will be much easier, and you’ll be much more resilient to financial shock.
Some good examples there Kevin. I use the 30/30/3 rule myself of 30% cash, 30% of income as payment, and 3X your annual gross salary max for buying properties.
I think that’s a bit stricter than what I go by, but those are pretty decent rules to go by, too, and cover several areas at once (the monthly payments, debt load, price to income). Will be harder to get into trouble if you stay within those limits.
Nice analysis. I agree with the 33% rule as a starting point. It’s tough today with such a crazy economic environment. When I bought my first house people told me to get the highest I could afford. It started out tough but with raises and bonuses it soon became quite easy to pay the mortgage. But it was during a stable economic environment. In those days people bought houses but it was a while before they put any real furniture in them. But still, for the most part, they could count on their job over a long period of time.
As time went on we put a nice addition on our house so that’s something to keep in mind for those who start out conservative.
I agree with your thoughts; I think starting out conservative is better, because if times are good you can always expand your living, but if times are tough, well, it’s not that easy to downsize your home. Buying as much home as you can afford means you’re forced to keep up that level for the long-term, but slack room is important to deal with shocks and also to be able to save more money for the long term.
Good analysis Kevin. We are under the 33% ratio, but I have since had a better idea than looking at the ratio.
I think you should buy a living space that is just right for you at the moment. This mean if you are single, buy a loft. If you are a couple, buy a 1 bed room or two bed room place. If you have one kid, buy a 2 or 3 bed room place.
Don’t buy for what will happen in the future. If you outgrow the place, then rent it out and find a new place. This is the way to build equity. What do you think?
I think as long as you’re under 50% ratio, this is ok.
I think I do agree with this, because if you make no use of the extra space and don’t need it, then it just becomes an extra expense and a place to store clutter. Me and the gf are going to be moving into a two-bedroom condo soon; at 850 sq. ft. it will be small (probably 950 to 1000 would feel just right), but it will also keep us from filling up the extra space with stuff we don’t need. I think it’s also enough space for our future needs, and if a baby comes along the way, a crib in the bedroom should be fine. I knew a couple that was surviving on maybe 2/3rds of the space while working overseas and they had a maid sleeping on the couch in their living room, too. 😉
We recently found a place that was about 2 miles away from us, more room, for a cheaper price! It’s lease-to-buy so we’re excited that our payments are going to go towards purchasing the condo. Just because you can “technically” afford it doesn’t mean you really can. You want to be able to contribute towards more things in the long run, like retirement.
Exactly, just because on paper you can “afford it” doesn’t mean you’re not giving up too much by doing so. I’m glad you mentioned that! 🙂
This really helps me in my research. I’ve been considering applying for a mortgage loan for a few months now and I’ve been concerned what percentage of my income should be used as rent. I could be comfortable with ~30%.
Whether as rent or as home carrying costs, I think ~30% or 1/3rd of net income is a decent guideline to stay under.
Good post Kevin. I would recommend potential home buyers to make the proposed calculations you suggested but using 5% as an interest rate as rates are set to rise sooner or later.
We won’t know for sure when rates rise, but it certainly doesn’t hurt to account for a potential raise in the budget. I agree; thanks for bringing that up, Mich!
Really good post.
I think that most people take what the lender tells them as being “what is affordable” or “what they’re approved for”, and just run with it. The reality is that affordability is a definition that can have many meanings.
To me, affordable means it fits within my overall financial framework, and allows me to save money for retirement, emergencies, and kid’s education. Also, however, it factors in some other contingencies, such as swings in property values, stickiness of the current housing market, etc.
Owning a home costs more than many people realize, particularly first-time homeowners. I have been given advice before that one should “stretch” with their home purchase, but I don’t see it that way. In my view, in a market where home prices are not expected to increase much more than inflation (if that), one must stay in a home for 5+ years, and factor in all repair/updating costs as well.
To answer your questions, choosing where to live is about school systems and proximity to work for me. Location, location, location:)
That’s the same idea that Briana Ford alluded to a bit higher: that “affording it” can mean different things, and that just because you have the money and can technically pay for it doesn’t mean it’s a good idea to spend so much money and do so. I agree with the both of you on that!
There is so much more that needs to be considered, as in what else you could be doing with that money and what you’ll be giving up in terms of lost opportunities.
Great article.
I have always been told that to be safe, the mortgage amount should be no more than 2 years income. So, if my wife and I make $100,000, I would be looking at houses valued at $200,000 or less. I like this rule, and honestly, I would like to spend only a little over $100,000 so that we could pay off the loan in less than 5 years.
Once that loan is paid off, it would be wealth building time! That honestly excites my wife and I alot more than having a mammoth house.
I think you’ll be very safe with that rule, as it’s stricter than my 33% rule (you’ll probably run around 20%-25% with that rule). The downside is that it depends on the market too, since in some markets you’ll effectively shut yourself out and then you have to look at how much the equivalent rent would be. In our market 33% is a good rule IMO, but there could be valid reasons for adjusting this (though I would recommend adjusting it downwards rather than upwards).
We’ve been in our primary residence for 10 years. Over time, as our income has grown, the mortgage represents a lower share of the monthly budget. Watching that “House Hunters” show on TV, I’m aghast at the amount of home that people, even young people, get in hock for. The end up being one financial disaster away from not being able to make the payment.
It does become easier as time goes on so long as interest rates don’t jack up too much. In Canada, the longest you can lock in a rate is 5 years (well, 10 years is doable but the premium is ridiculous), so, I really do agree with not biting off more than you can chew. If someone loads up now at 3%, what are they going to do if rates are at 6% in 5 years from now?
Great article! I agree with 33%. I remember buying our condo and getting a quote from a bank. When I heard what they thought we could afford, I was thinking “really?” “are you serious” “we do need to eat as well…” LOL Banks really want to put you in a debt for life.
Haha. Well, it definitely is in their best interest…
Totally agree on a lower amount than the banks offer. When we went for our home loan the banks were offerings MILLIONS (I mean like $4 to $5 million). Seriously, even on our income we could never have paid it off. AND they got upset when we knocked them back! It was like we were personally insulting them or something.
I also agree that you should stress test your loan. What happens if interst rates go back up to 5% or even 10%? Seems a long way off, but it can happen.
That is one heck of a loan! Stress-testing is a good idea. 10% is probably a long way off, but we’ve seen those rates before. If 10% brings you up to 50% that’s not horrible, but if you’re already at 50% now… you’re basically screwed if the rates jump up!
I agree that 33% is closer to the number you should be aiming for. My husband and I spent hours upon HOURS of figuring out exactly how much we could comfortably afford. Then, after settling on that number, we changed our mind and decided to only go with a house that one person could afford. That way, if one of us became unemployed, we could still make payments. When that equated to a number too low, we split the difference. When we went to the bank to get a loan, they gave offered us an amount over DOUBLE what the highest “affordable” cost we had calculated! We ran away screaming! Okay, we just hung up.
Haha. I know that if we had gone for the max, we’d be pretty near the limit for the next few years. Then if someone lost their job… would be tough. Layoffs are already striking near home, so I’m glad that we can still make the payments even if the axe should fall on one of our necks.
Great article! My mortgage and taxes are about a 1/3rd of my take home pay (after taxes and 401K contributions). I put about 30% down when I bought the house. If I had taken the bank’s suggestion for what I could afford there is no way I’d be able to make the payments. This article should be mandatory reading for anyone thinking about buying a home.
Thanks for the validation! That’s interesting in that you’re at 30% after the retirement deductions. Although this is a discretionary deduction, it’s certainly not a bad idea to take it out of your net income for this purpose, since we should always pay ourselves first…
Good article! I would like to add another perspective, the bank looks at the risk of the loan and the ceiling of what they are willing to lend. They also know that psychologically you will do anything to avoid foreclosure. In other words, they are looking out for their best interests. You want the most because of housing prices and maybe a limited down payment. Buying a house is an emotional decision and difficult to separate oneself to really think about how much you can afford. Everyone should use your rule of thumb that way we would have avoided the housing crisis.
Very true. It’s amazing how many out there are trying to exploit those feelings, whether it be the real estate agent that says “if you’re looking for a place, you should definitely buy now, because prices are going up”, or the mortgage specialist that says “Rates are definitely going up, so I suggest you get this long-term fixed rate at a much higher premium”. To be fair, our mortgage specialist was pretty objective, but they all play the fear game to some extent. I guess no matter what has happened before, “this time is always different”.
Good article. Quite timely for my wife and I with moving into the new place over the last week. I think our mortgage ratio is about 20% of net income. Add property taxes, gas, hydro, insurance, maintenance and we’re about 30%.
We plan to be here for some time and we’re locked into a rate for a few years when they start inching up in 2011. Don’t they have to Kevin? We’ve budgeted our mortgage payments for 6% rates (we’re paying half that now).
30% is pretty good! I’m glad that you found a good home, and don’t have to get up to your neck in payments for it. I think that rates will be rising for sure. I don’t see 10% due to the negative economic and political consequences (though it’s always possible and shouldn’t be ruled out entirely), but a return to the norm of at least the past decade is to be expected. That suggests an overall rise in the range of 2-3%.
It’s always better to buy a little less than you can afford.
I guess this is applicable to pretty much everything. It’s always good to have some slack in your budget — if things remain good, then great, more money to save, but if things turn for the worse, then you can bend instead of breaking.
This is great advice. I get so angry when I think about how our mortgage broker (and realtor) tried to push us toward spending the max we were approved for. I am so glad we didn’t. I can see where some people would be tempted though, especially since prices have really dropped in recent years.
You are so right about not wanting to be the poorest person in a rich building. What exactly is the purpose in that? It is always good to live where you will be comfortable in your own skin. Constantly striving to keep up with others is a bummer, and you are setting yourself up for disappointment and spending for the wrong reasons.
Can you imagine how people here are getting pushed toward the max, although Canada’s housing market is near a peak? We might not collapse US-style, but there’s no reason that housing prices won’t stagnate, combined with rising rates, turning many debtors into virtual slaves and zombies. Not a fun place to be.
I’m glad we share the same thoughts regarding the living space. Many human psychological factors are relative, which means that if you have the crappiest unit in a building meant for richer folk, you’ll feel poor, especially if you are paying out the nose for mortgage payments.
It is good to surround yourself with people you can aspire to, but ostentatious spending isn’t really on my list of qualities to aspire toward. I prefer the type of rich that know how to invest their money and time wisely, not those who simply know how to spend or borrow a lot to keep up appearances. 😉
People forget about carrying costs and that can really sink you. I advocate the same for tenants as well. Rent is very expensive here in NY and it’s not unusual for more than 50% of your income to go to rental payments. I advocate tenants where 1/3 of their income goes to rent as well.
50% ouch! At least if you can’t pay the rent you don’t lose everything (mortgages in Canada are full-recourse, but don’t pay rent and the most that happens is that you have to go find somewhere else to live).
Our mortgage costs work out to something like 60% of the total costs once you look at the property taxes and everything else, and the property taxes can vary significantly from city to city, so it is definitely important to look at the total costs!
Good and “Solid” advice. It’s true, that life is full of surprises. One of the worst things, in my opinion, would be having to live “house poor.” I think a lot of people were or are house poor. They gambled the farm betting on the best case scenario being a sure thing.
What’s the point to carry on scraping by only to pay the mortgage for 30 years? I think something is backwards here? Banks are in business to make money.
A good rule of thumb is to live with 6-9 months of living expenses in cash equivalents (IMO) and figure out how much of a payment you can comfortably afford BEFORE you start looking. This way you don’t end up living house poor, only to go into foreclosure.
If rates rise 3%, a lot of people are going to be house poor. It depends on the city, because a working couple making 80-100k gross with a 300k house will probably be fine if rates rise 3%, but a couple making, say, 110k with a 550k house will be looking at a world of hurt. My nightmare is waking up and finding that I’ve become a debt zombie.
There’s nothing fun about being house-poor. When we bought our first house we had to go to the top of our price limit just to get into the market (and we didn’t buy anything fancy). The first 2 years were so tight. We couldn’t even afford to paint or landscape, things I dreamt about doing when I finally got my own house.
After 15 years of home ownership, our income has risen and interest rates have dropped. Ten years ago, when we moved up to our current home, we did not go anywhere near the limit the bank had suggested. Now our mortgage/tax payment is less than 20% of our take home income, much more manageable. Our mortgage will be paid off in 5 years.
People often anticipate that their income will rise and the payments will be more affordable. That is partially true, but it seems that their will always be something else you can spend the difference on. Right now we are in the stage of life where we have a daughter away at university. Thankfully we are able to help her financially because we have that extra cushion.
15 years ago, the market was pretty tough, wasn’t it? Weren’t the rates 10% and up? It must have been pretty burdensome meeting those high-interest rate payments. I’m glad to hear that you’re at only 20% these days.
At least with rates so high to begin with, there wasn’t as much danger of them going up much higher. The scary thing about today is that many people are leveraging themselves to the point that you mention, but the rates are much lower today. What happens should rates go back only to where they were 10-15 years ago?
15 years ago, our interest rate was 8%. At the time it was a great rate, we were happy to have it.
Too bad the banks decided to not use the stimulus funds to give out loans as they had promised.
I wonder how the excess reserves will be mopped up in the end? Loaning out all of those funds would be setting up one mother of a bubble down the road. Although a full collapse of the banking system isn’t too conducive to law & order, I’m of the school of thought that believes that taxpayer-backed bailouts are essentially a theft of resources from the productive to the unproductive, and from the moral to the corrupt and unethical. There were surely better alternatives than the path that has been chosen by the powers that be.
I love the ratio you give – especially taking the total home carrying costs into consideration, which is one area many people fail to consider. Taxes in our area are very high, and it dramatically reduces the amount of house I would be willing to buy, simply because it would substantially increase our mortgage payment. The other consideration many people underestimate when moving into a larger home is utilities. Heating and cooling a house that is twice the size as your former home can cost more than you think, and it can be difficult to estimate because many factors can contribute to the efficiency of your heating and cooling: size, insulation, personal preference for temperature, which direction your house faces, utility providers, etc.
The difference in taxes between two different areas is one of the main factors that compelled us to make our decision, as well. The difference in price wasn’t all that much, but after you added in all of the costs the difference was actually huge! We would have been close to 50% in carrying costs for not a big difference in the actual mortgage, and there were some non-tangible drawbacks as well.
Thanks for the great comment!