How Much Should You Spend on a House?
This question is perhaps one of a few key questions in your financial life that can either make you or break you when it comes to your finances. Unfortunately, there is a lot of confusing information out there about how to make this critical decision and more than a few articles that do more harm than good.
My goal with this blog post is to give you a frame work for considering this question so you can make the most of your dollars and land the house of your dreams without breaking the bank.
Risks Associated With Owning a Home
One approach to answering the question of how much you spend on a house, and the approach I favor, is to develop a framework that mitigates the financial risk of buying a home. With that in mind it is helpful for us to take a look at what the risks are before we consider what rules we might want to put in place.
Purchase Price Risk: One of the most obvious risks of buying a house is that the principle and interest payments will be overwhelming and result in negative cash flow due to the mortgage.
Interest Rate Risk: Some mortgages are offered with a floating rate. The purpose of these loans is to shift the risk of interest rate fluctuations off the lending institution and on to the borrower. In a rising interest rate environment these loans can become too expensive for the borrower and result in a forced default.
Property Tax Risk: Often overlooked when considering housing options is the taxes you might have to pay on your property going forward. This risk can materialize for two different reasons. First, a county may raise their property tax rates. Second, the value of your home may be assessed at a higher level resulting in a larger total tax bill.
Market Risk: This risk simply reflects the fact that housing prices do not always go up. If for any reason you need to sell your home and the net price you can sell your home for is below the purchase price then you are what is called "under water" on your mortgage. In other words, you will still owe money on the home after you sell it.
Income Risk: In a perfect world our jobs and income would be secure and we would never have to worry about lay-offs, company reorganizations and just outright getting fired. Unfortunately, that is not the world we live in and so we need to be mindful that we may one day be making less money than when we originally purchased our home.
Insurable Risks: There are a number of risks that occur somewhat infrequently but are coverable by the proper insurance policy. There are too many to name but for our purposes we do want to recognize them so that we account for them in our decision making process.
Insurance Rate Risk: Like your local tax assessor, the insurance company has the right to raise rates on what you pay from time to time. It is critical to have homeowners insurance to protect your assets but it also important to understand that the payments to cover those risks come at a cost that can vary.
These risks can be boiled down into two broad categories, loss of capital and reduced cash flow.
Loss of Capital
The simplest way to put your capital at risk is to deploy too much of it on any one asset. This rule goes for your investment assets just as readily as it goes for your personal-use assets. For example, if a person purchase a house at a big sticker price and is forced to sell it while the mortgage is underwater than they will be in a position that they may have to sell that home at a loss and continue to pay the mortgage note. Similarly, if you are forced to sell a security (stock or bond) for less than you purchased it you will realize a loss of capital.
Reduced Cash Flow
Reduced cash flow can be the result of many different variables changing. The obvious risk is that you lock yourself into principal and interest payments that are too high. However, you should also consider costs associated with your house such as the property taxes, home owner's insurance and maintenance. All of those factors can make a seemingly affordable house unaffordable in a hurry.
Other factors to keep in mind are those that affect your income and other expenses. Some common risks include reduced income from salary & wages, and increased costs of healthcare, education and transportation.
Debt-to-Income Ratio or Price-to-Income Ratio
One way to mitigate these risks is to employ a limit on the sticker price of the house you purchase based off of your income. The idea is to limit the financial risk relative to your income. By doing this you could have the financial resources to pay down the debt you owe a house you had to sell even if it were under water. By extension, this limits the nominal purchase price of the house and puts less of your capital at risk when you consider any principal payments or down payments you have put towards the mortgage of the home.
An often cited rule of thumb for a "healthy" debt-to-income ratio is that total debt payments should be no more than 36% of your gross income, and mortgage payments as a subset of total debt payments should be no more than 28%. By inverting this ratio one might suggest that your mortgage should be no more than 4 times your annual salary.
While this is a convenient rule of thumb it is by no means what you as an individual should necessarily follow.
If we take a look at what wealthy people tend to do we find that they keep their total purchase price of their homes to about 1.5 times their annual salary. This rule of thumb does more to mitigate their risk by eliminating the perception that a big down payment eliminates all their risk and does more to reduce their principal and interest payment obligations as well.
Another factor that might be at play is if you live in a high cost of living city. My friends and family in NYC or San Francisco will be quick to note that if the average cost of a house is a million dollars than you would need to make at least $333,333 in gross income to adhere to that principal. Clearly not everyone will be able to do this. Just keep in mind that whatever extra money you spend on housing needs to come out of some other part of your budget. Don't fall into the trap of being "house rich and life poor". What good is a nice house if the rest of your life is miserable?
If you are looking for an financial expert to help guide you through a home purchase please reach out. Sign-up for a complimentary consultation using this link.