This isn’t always the way the question gets asked, but it is often the question behind the question. As advisors, we often serve as the voice of reason to encourage housing purchases that make sense or to caution against purchases that may lead to regret.
This question is also even harder to answer in a rising interest rate environment mixed with low housing inventory.
I like using rules of thumb, not as a be-all and end-all, but as a way to quickly size up a situation. My typical rule of thumb is that if a client mortgages 3x their income (or more), they will eventually feel house-poor. Notice I said “mortgages” because the purchase price and the amount mortgaged matter because they are different. If a client makes a large down payment, then we need to account for that difference. A few caveats first: this is what I consider the max (not necessarily the recommendation) and I usually would not include bonus/variable compensation in the formula unless it has been found to be very reliable.
The math in action: If a couple makes combined wages of $250,000, then the 3x mortgage would be $750,000. Let’s say they are considering a $1 million purchase with a $250,000 down payment. The monthly P&I for a 30-year mortgage at a rate of 7.5% would be roughly $5,250/month plus property taxes of $1,000-$2,000/month (depending on where you live in the country), plus utilities of $1,000-$2,000/month plus likely repairs and upkeep of $10,000-$20,000/year.
This means that at a minimum, this couple would need to use about $95,000 per year of cash flow to live in this house. Assuming their after-tax income is $200,000, this already accounts for 47.5% of their after-tax income. This is barely feasible if they have no other debt (no car payments, student loans, etc.), but likely way too much if they have other significant fixed expenses. The 50-20-30 rule (50% for fixed expenses, 20% for savings and 30% for discretionary expenses) should be an absolute max (after taxes). This would leave just 2.5%, which isn’t much depending on the rest of their lifestyle.
For most clients, keeping the mortgage max well under 3x would be much more comfortable. I like thinking of a range between 1x and 3x income as the likely landing spot for a mortgage amount for most clients. In the last 18 months, mortgage rates have gone from 3% to 7.5%. In this new world, a max of 2x is likely wiser, but I give a large range to give some freedom.
Why is this important? First, I’d recommend shopping inside of your price range. Touring houses outside of your price range can lead to overspending. Second, your house is likely your biggest financial anchor. It is hard to find money for saving, charitable giving or traveling if all of your money is going to your house.
A few final thoughts:
1. Giving advice can be tough. Especially when it is advising a client not to buy something they want to buy. I often tell clients that it is not my money, but they are paying me to be an objective advocate for their current self and their future self. I need to give advice that blends enjoying today while also not being too financially restrictive to their future self. I often ask the question, “If buying this house meant that you’d need to change other financial goals or spend less in other categories, would that be OK?”
2. On the flip side, giving advice can be fun. I’ve had clients that I’ve had to caution, but I’ve had many more that I had to give permission to do something they could easily afford. Helping a client see what is possible can be the most rewarding part of my job.
3. Always do the math. Install a mortgage calculator on your phone and research property taxes on Zillow. Estimate utilities and also add estimates for repairs and upkeep — the older the house, the more this number should be.
4. Making the right decision is about more than money. I use 3 Cs: Community (Do friends and family live nearby?); Customs (Is the area walkable, easy to hike, bike or do the other things you enjoy?); and Commute (Is it easy to get to work and kids to school?).
5. Remember that these rules may need to be tweaked for retirees. If a retiree chooses to have a mortgage in retirement, I’d consider their income using the 4% rule (percent of spending of total retirement assets) and still make sure you are under 3x. (Many of my retired clients have chosen to keep a mortgage because they have a low rate locked in from a few years back)
Hope this brief article gives you clarity on your housing decisions.
Want to learn how much house you can afford? Visit LiveWell Capital at
LiveWellCapital.com for more information. LiveWell Capital is located at 3805 Edwards Rd., Suite 200, Cincinnati, OH 45209.