How Much House is Too Much? A Different Approach to House Hunting
For most people, their home is likely the biggest investment they’ll ever make. So, how much of a home can one afford? Most people start by asking their mortgage broker or loan officer how much house they can afford and how much they should put down, and then start house hunting. This approach is externally focused and lets others dictate not only how big a home you’ll have, but dictate almost all financial aspects of your life that buying a home will affect.
A more holistic approach would be to look at what you want in life overall (retirement, sending kids to college, starting a business, etc.), and then buying the right sized house that helps you afford all these goals. A well-developed financial projection model that looks at your entire financial life picture can help you do this.
Start with a budget. The first step to developing a projection model would be looking at your current spending and savings patterns. Apps like Mint are great tools to quickly auto-generate a budget and get a detailed report of where your money goes by category (food, transportation, rent, utilities, etc.). There might be the temptation to look at the last month or two of expenses and strip out one-off expenses like a weekend holiday or going to a friend’s wedding. However, you’re likely going to have some sort of “one-off” expenses every month for the rest of your life, so looking at the last 12 months of data would give you a better idea of real spending patterns.
Estimate your annual savings and the cost of your goals. Once you know where all your money is going, then separate how much money is going toward savings every year in all of your accounts (checking, savings, brokerage accounts, 401K, etc.). Once you have your annual budget and savings patterns, then start defining what your long-term financial goals are and estimate what they cost. The most common goals would be saving for retirement and saving for your children’s education. Given that expenses tend to increase every year, don’t forget to account for inflation. For example, if you are spending $80,000 annually today at age 35, you’ll need $167,000 annually at age 65, assuming a 2.5% inflation rate.
Build your projection model. This will involve a bit of spreadsheet work. If that’s not really your thing, you can work with your financial planner or financial advisor to develop financial projections to see if you are on track with your savings to fund your future goals. You should project the amount of savings each year over your lifetime and the earnings rate on those savings to determine if each of your goals has been funded. Start with projecting mortgage payments equal to your current rent, and the projections should account for your down payment. If the projections show you are on track with your savings with some cushion, then you can afford to take on a higher mortgage payment. If you aren’t on target yet, then perhaps you should take on a lower mortgage to increase your savings rate.
Many people look at the after-tax mortgage payment for projections, but this can be problematic. Each mortgage payment is part interest payment and part principal payment. As time goes on, your interest deduction decreases over time, as principal payments become a larger and larger part of each payment. The maximum deductible mortgage decreased from $1,000,000 to $750,000 in December of 2017 as a result of the TCJA as well, so it’s possible the mortgage deduction could be further reduced or fully eliminated by Congress in the future. Your advisor may have software like eMoney that accounts for the changes in the mortgage deduction over time.
Change the assumptions. Projections can be very useful, but life can be unpredictable. Run various scenario analyses: what if you or your spouse lost your job for say six months? What if you had to retire earlier? What does this do to your retirement projections? How would $100,000 more or less in a mortgage affect reaching your other goals? Projections are only as good as their inputs, but projections can be helpful in making important life decisions and can be helpful in understanding the trade-offs of certain decisions. For example, the projection model might show that buying a home that’s $900,000 instead of $700,000 would mean working until 67 years old instead of 65 years old. A properly built projection model can help illustrate those trade-offs right away.
Right Sizing your Home. Buying the right sized home can mean a world of difference in terms of making the right financial decision for your family. While a mortgage broker or bank may say that you can handle a mortgage payment of up to 28% of gross income or total debt payments up to 40% of gross income, these guidelines might not work for you. As well, you don't have to buy a home. You can still build wealth and accomplish your financial goals while renting.
If you do end up with a home you can’t afford, you could be saddled with ever-increasing maintenance expenses such as utility bills, real estate taxes, insurance costs, lawn care, repairs, the list goes on. What can you do if you already have a house/mortgage you can’t afford? There’s really only four options: spend less, make more, sell the house and rent, or sell the house and buy a more affordable house.
Downsize in Retirement? A lot of us have been told to stretch and buy the biggest house we can afford. Downsizing in retirement is often the justification for buying a house you may not be able to afford. This can backfire, as your house shouldn't be your retirement plan. Downsizing in retirement usually doesn't work out like people envision it will. Convincing your spouse that you need to sell the house and move to a different neighborhood can be hard to pull off. As well, selling the house at the onset of your retirement could coincide with a down market. Downsizing to fund retirement puts the success of one's entire retirement at the mercy of market conditions of one real estate transaction. Baby Boomers are entering retirement in droves, and a wave of retirees looking to downsize their homes to fund their retirement could end badly for the single family home market.
Overall, when determining how much you can afford, a properly built projection model can avoid bad real estate decisions and put you on track to achieving all of your goals.
David Wilson, CFP®, CFA, CDFA®, CCFC is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Wealth Advisor at Watts Capital. He can be reached at email@example.com.