With interest rates at historic lows and growing concern about a rise later this year, we have been fielding many questions about home buying and affordability. Most people have an idea of what they “think” they can afford but they come to us asking what they should do in comparison to where we see how our other clients allocate their cash flow.
Rules of Thumb:
Your total housing expense (principal, interest, taxes and insurance) should never exceed 28% of your pre-tax income. For example, if your household income is $100,000 before taxes, you should not spend more than $28,000 a year or $2,333 per month on housing.
Your total debt payments (housing, cars, credit cards, student loans, etc.) should never exceed 36% of your pre-tax income. For example, if your household income is $75,000 before taxes, you should not spend more than $27,000 per year or $2250 per month on all debt payments.
*Disclaimer, these are “rules of thumb” obviously you must individualize for your personal situation and their may be some circumstances where these rules do not apply or may be adjusted. For example, if you have no debt except your mortgage you may be able to spend 29% to 30% pre-tax payment, instead of the prescribed 28%.
Rock Star Status
What’s the right amount to spend on housing if you want to be a “financial rock star”? In my experience, when our clients spend between 20% and 23% which leaves cushion for meeting a 15%-16% income allocation for annual savings toward wealth building.
Let’s run an example
John and Sally have the following financial information:
John’s Earned Income: $45,000
Sally’s Earned Income: $75,000
Total Household Income: $120,000
Rules of thumb:
John and Sally’s top end housing expense: $2800 per month
John and Sally’s top end total debt expense: $3600 per month
John and Sally have no debt outside of their mortgage except for car payments. They really like to have nice, new cars so they are currently spending $1050 per month on car payments. If they want to keep these cars they should spend less than $2550 on housing to keep their total debt payments below the recommended 36% of pre-tax income ($3600-$1050= $2550).
Assuming that John and Sally choose a 30 year mortgage with an interest rate at 4.50% APR, pay 2.2% per year in property taxes and $1450 per year in insurance then they could afford a $345,000 property at the high end of our rule of thumb. If they want to shoot for “rock star” status and have housing expense be only 21% of their pre-tax income they should spend $285,000 on a property with the same assumptions as above.
|High End||Rock Star|
|Monthly Principal & Interest||$1,748.00||$1,445.00|
|Monthly Property Taxes||$633.00||$523.00|
It comes down to values
Ultimately, the amount you choose to spend on housing comes down to a values decision. We believe that great financial planning should enable you to spend lavishly on the things you care about and cut mercilessly on the thing you don’t. Money is a finite resource, regardless of how much you have, and there are an infinite number of things you could choose to spend on. The trick is to determine what you value enough to spend your hard earned resources on. At Hiley Hunt Wealth, our role is to help you find that place where your money and your values meet.