After a long year of quarantines, social restrictions, and working from home, many people have been looking for a bigger house that will meet their family’s needs. After perusing the Zillow listings with a cup of coffee on a Saturday morning, a common question you may ask is, “Can I afford this house?”
Let’s explore three questions that will help you determine the affordability of your next home. If you can answer “yes” to these three questions, you probably can afford it.
- Does your monthly cash flow support a higher mortgage payment?
- Will you still have a sizable balance in your cash and taxable investment accounts after the down payment?
- Can you accept the possibility of delaying your retirement to afford the home?
The 28 Percent Rule
Does your monthly cash flow support a higher mortgage payment?
The first thing people consider is if they have room in their monthly budget for a bigger mortgage payment. A commonly cited rule of thumb suggests you should spend less than 28 percent of your monthly gross (pre-tax) income on your mortgage payment including principal, interest, property taxes, and insurance. This rule of thumb is a good starting point, but not a complete method for evaluating how much house you can afford.
For example, imagine a couple with a combined gross income of $165,000 is evaluating a purchase of a $750,000 house. If they make a 20 percent down payment, their monthly payment (including insurance and taxes) with a 30-year mortgage loan would be about $3,800. They would meet the 28 percent mortgage-to-income rule. However, the rule does not account for other financial implications. As we continue onto the next question, we’ll look at another example to explore these factors further.
Will you still have a sizable balance in your cash and taxable investment accounts after the down payment?
What if the same couple wanted to buy a $1,500,000 house instead? As long as they make an 80 percent down payment, their monthly mortgage would be about $3,800—the same as the $750,000 house. However, the couple would need more than $1,000,000 of additional funds for the down payment to afford the monthly mortgage for the more expensive home.
This example illustrates that the 28 percent rule does not account for the opportunity cost of money needed for the higher down payment. The opportunity cost is the foregone investment return on the extra down payment amount. It also ignores that the extra cash outlay for the down payment may substantially reduce their cash reserves and make them “house-rich and cash-poor” for a while.
|Property Tax and Insurance||($15,000)||($20,000)|
|Opportunity Cost of 20% Down Payment*||($9,000)||($12,000)|
|Mortgage Interest Expense**||($18,000)||($24,000)|
|Home Price Appreciation***||$15,000||$20,000|
|Annual Cost of Homeownership||($27,000)||($36,000)|
*Assumes that they will earn a 6 percent return if they invested their down payment.
**Assumes a 3 percent mortgage interest rate. For simplicity’s sake, we ignore any potential tax savings from the mortgage interest deduction.
***Assumes 2 percent annual growth rate in the value of each house.
This table highlights a non-exhaustive list of factors that contribute to the annual cost of homeownership. Note that none of these factors include the monthly mortgage payment amounts. The difference in the annual cost of homeownership between the two houses is $9,000.
Other Homeownership Costs
Here are other factors that contribute to the cost of homeownership that are difficult to quantify:
- Maintenance/furnishing costs—More expensive houses typically have more square footage, which typically means higher maintenance costs and more furnishings to purchase.
- Lifestyle creep—Does moving into a higher-end neighborhood make it more likely that you will want to keep up with the more expensive tastes of your new neighbors?
- Transaction costs—Very few people live in the same house forever. Suppose you think that you eventually will move into a more expensive home. In that case, you might be better off buying it now rather than choosing the less expensive house and incurring transaction costs such as realtor commissions and loan closing costs when you move.
Can you accept the possibility of delaying your retirement to afford the home?
If the couple chooses the more expensive home, their annual contributions to their retirement accounts may decrease to meet their short-term budgetary needs. Ultimately, this means they may have to delay retirement for a few years or find other budget areas to reduce expenses. The affordability of the home goes in hand-in-hand with the willingness to accept the trade-off of working longer or cutting other costs.
How We Can Help
For many of our existing and prospective clients, the key question is not whether they can afford the more expensive house. The real question is whether they are comfortable with the trade-offs they may need to make if they buy the more expensive house. Learn more about our approach, and how we’re able to quantify the trade-offs to help you make a more informed purchase decision. Get in touch with us.