My best buddy and his wife came to visit me the other week. You know him as O-man, an old friend I’ve mentioned in past blogs. (O-Man–don’t let me blogging about you go to your head, you hear?)Anyway, he told me about some exciting stuff going on in his life, namely that they bought their dream house. It’s a super cool house, and I’m really excited for them. The house checked off all the right boxes for them, although it came at a steep price. Apparently, the Washington D.C. real estate market is a bit pricier than the Brandywine Valley. While talking, the topic arose of how much do I “recommend” he can afford for a house. I won’t divulge the dirty details of the O-man, but I will give you a few different ways to approach this topic.
The mortgage broker way.
Probably the worst answer is to look at what a mortgage broker would give you. It’s not that I don’t like mortgage brokers, but their job isn’t to talk you in, or out, of a house. They provide a service of procuring you the best rate they can. (By the way, Diversified, LLC works with some great ones.) If you ask a mortgage broker, they’ll tell you take 45% of your gross income, subtract out any minimum payments for debts, and you’ll have the maximum payments for which you qualify.For example: let’s say I make $100,000 per year. 45% of that is $45,000/yr. Take out my car payment of $5,000/yr and you are left with $40,000, or a $3,333/mo payment.I hate this way, as it most likely stretches you very thin.
The multiplication method.
You don’t have to understand the “new math” they are teaching my kids these days to figure out this next method. The multiplication method says take your gross income and multiply it by 2.5.(Sorry… were you waiting for more?)That’s it! So, if I make that $100,000 per year, my home should be approximately a $250,000 loan. This assumes I put the traditional 20% down. Oddly enough, I don’t hate this method as much as the mortgage broker way. I wouldn’t write a financial plan based off this method, however. But under normal circumstances, I do think this gives you a general sense of your price range.
The Dave Ramsey method.
The radio personality, Dave Ramsey, generally calls for a more conservative approach. Being I am also more conservative when it comes to finances, this speaks to me. He recommends no more than 25% of your take-home pay should go toward your mortgage, property tax, and insurances. Therefore, if my take-home pay is $100,000/yr, my all-in mortgage cost shouldn’t be larger than $2,000/mo. This is quite conservative compared to the other strategies–that isn’t to say it’s good or bad. However, if you fall into this category, you’ll have a nice chunk of change to spend on other aspects of your lifestyle. This strategy also takes the most discipline, which makes it harder to do.
The online method.
In the great technological world we live in, there are tons of online calculators. I happen to like this one by Zillow. To be honest, though, there are too many to count. Use one and in a few minutes, you’ll get a result as to what you can afford.The pro is that these can be pretty comprehensive and gives an oddly-exact projected figure. The con is that they are very impersonal and don’t do a good enough job of understanding your entire financial landscape. In the end, these are fun tools that do a fair job of giving you something tangible to work with and help generate an idea.
The best method.
Of course it’s… MY METHOD! Shocking right?(O-man was equally not shocked, but hey I am biased.)The issue with everything above is that it’s very one dimensional. They are all focused on income and/or take-home pay. While I do agree that is a huge component, I prefer to use a more financial and comprehensive approach.For starters, I like to go through my non negotiables. They are: Saving AT LEAST 15% for retirement. Understanding monthly expenses that will continue post home purchase. Having a discussion on uncompromising family priorities (i.e. paying for children’s college).
Assuming you are currently on track before purchasing that new home, I’d walk you through the following exercise. First, I’d determine if your current savings rate is going to get you comfortably retired.
This is critical as it is generally highest on most people’s goals list. I’d hate for anyone to let a home get in the way of their ability to retire. Second, I would then do a thorough exam of your current monthly expenses.
If you are saving the right amount for retirement, you should be able to determine two things– do you have tons of fluff left over each month or are you living paycheck-to-paycheck? If you have a lot left over and are living well within your means, you can afford more of a home. If not, I’d stay put! Lastly, I’d help prioritize your goals.
This one gets missed more times than not. We get so enamored on a shiny, new house that we fail to realize the residual affect it has on our financial goals. What makes you happier: putting your kids through college or living in a big fancy house? A lot of times these decisions become that binary. There is no right or wrong answer, but it warrants a discussion with your significant other to make sure you are both on the same page.
Again, none of these plans are necessarily wrong. The reason I like my plan the best is that it gives more depth to the conversation. A home is a very emotional purchase, no matter how hard we try to remove emotions from that purchase. Thus, I recommend getting ahead of things. Look to have the dialogue before you go out looking. That way, everyone will be aligned. When that happens, smart financial decisions are made!I hope you enjoyed this article. If you see O-man or O-woman on the streets of D.C., give them a big congratulations (as now they have room for the Rosen’s to crash)!