How Much House Can You Afford?
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
Buying a home is one of the biggest financial decisions you’ll ever make. Knowing how much you can afford is critical to securing your long-term financial future. What makes a home affordable or not, is whether you can buy and maintain it, while also maintaining your living standard and meeting your other financial goals. A secondary, more tactical, set of questions involves how to finance the purchase and whether to pay off your mortgage ahead of schedule. Note that deciding whether to buy or sell an investment property involves an entirely different calculus. In what follows, I layout the process of evaluating how much house you can truly afford.
Don’t Listen to Your Mortgage Lender
Mortgage lenders use various debt-to-income ratios, along with credit scores and other financial information, to decide how large of a loan you qualify for. Most borrowers don’t qualify unless their debt-to-income ratio is below 36%. This means your monthly mortgage payment, including principal and interest, plus taxes, insurance and any other debt payments, must be less than 36% of your gross monthly income. Lenders then use these ratios to recommend how much house you can afford. Don’t be fooled! What they’re actually doing is calculating how much loan you can afford.
For the lender, affordability is about extracting as much profit from you as possible without taking on too much default risk. This means recommending the smallest down payment as is acceptable to the seller, and taking out the largest loan as is feasible based on your income.[1] Clearly, this approach has nothing to do with you or your financial goals. Relying on a mortgage lender, realtor or other salesperson to decide what is affordable is worse than asking your barber if you need a haircut.
Home Affordability Depends on Your Plans for the Future
Whereas a mortgage lender or realtor boils their recommendation down to a single (useless) ratio, a good financial planner will analyze what is affordable within the context of your lifetime financial plan. If buying and maintaining a certain property means having to reduce your desired standard of living or sacrifice other committed financial goals (like college for your kids, extra travel in retirement, gifting to family, etc.) the house is simply not affordable.
To figure out how much house is truly affordable, you need to consider your lifetime balance sheet. This approach is built on the idea that you can’t spend more over your lifetime than you have in financial resources. Simply put, your lifetime spending, including that on housing, must be equal to your lifetime assets.
Lifetime Assets = Lifetime Spending
This framework allows you to explore the affordability of different housing scenarios. Consider the example of Wanda Worker, a 40-year-old software engineer, who wants to buy a home. She has her eye on two properties, one priced at $350K and the other at $700K, with operating expenses as shown below.[2] Assuming Wanda were to live another 60 years, we can reasonably assume that lifetime expenses for each property, including the purchase price and operating expenses, are $1.085M and $2.17M, respectively (see highlighted cells).[3]
Lifetime housing expenses include the purchase price and all ongoing operating expenses
Using Wanda’s lifetime balance sheet, we can determine whether either of these properties are affordable from a lifetime perspective. In other words, after accounting for her lifetime spending on things unrelated to housing, like insurance, taxes, goal-related expenses and discretionary spending, will she have enough lifetime assets leftover to cover her planned housing expenses? Assuming Wanda’s lifetime assets amount to $6M, including future earnings, Social Security and current savings, and her non-housing lifetime spending amounts to $4.4M, she’ll have $1.60M leftover to spend on housing over her lifetime (see chart below).[4] You can think of the $1.60M as her lifetime housing budget.
Wanda’s lifetime balance sheet shows that she’ll have $1.60M to spend on housing over the rest of her life
Now, if Wanda purchases the $350K home and maintains it for life, she can expect to spend $515K less than her lifetime housing budget ($1.60M - $1.085M = $515K). Clearly, this property is affordable. In fact, if she buys it, she could afford to spend more elsewhere or otherwise reduce her lifetime earnings (e.g., by possibly retiring early or downsizing her career). If Wanda instead purchases the $750K home, she can expect to spend $570K more than her lifetime housing budget ($1.60M - $2.17M = -$570K). This means the property is unaffordable, unless she were to earn more or spend less elsewhere.
Based on Wanda’s lifetime housing budget of $1.60M, she can technically afford to purchase a home up to $516K. This is a far cry from what a mortgage lender, realtor or online calculator is likely to recommend, which based on her annual income, might qualify her for a loan to purchase a property worth over $1M!
Conclusion
Homes are expensive and for the most part are NOT an investment, unless you rent the property to someone else. To decide what is truly affordable, it’s vital to look beyond the monthly payment and dubious advice from mortgage lenders. Mapping out your future, including lifetime projections for income and spending, can allow you to most accurately answer the question of how much house is affordable.
Footnotes
[1] For example, if you earn $100K a year and have no other debt, a lender might say you can afford a monthly payment of $3K ($100K x 36% / 12 months = $3K). Based on reasonable estimates for taxes and insurance, a 30-year fixed rate mortgage at 3% and a 20% down payment, this implies a home purchase price of $680K and loan amount of $544K.
[2] For simplicity, I assume property taxes, insurance, utilities and maintenance are a fixed proportion of the sales price (1%, 0.25%, 0.75% and 1.5%, respectively).
[3] For example, $350K + 60 years x $12.25K = $1.085M. For simplicity, this assumes Wanda buys the property outright. If she were to take out a loan, her operating expenses would include principal and interest payments on the loan. Expenses are assumed to keep up with inflation and lifetime totals are shown in today’s dollars.
[4] Wanda’s lifetime assets include $4M of future earnings, $1.5M of future Social Security and $500K of current savings. Her lifetime non-housing spending includes $200K on insurance premiums, $1M on taxes, $500K on goal-related expenses, and $2.7M on discretionary spending ($45K per year for 60 years).