Can we afford that house? Rules of thumb.
March 19, 2018 | By Kevin Smith
There is usually a difference between the house we really want and the house we can actually afford. Figuring out a reasonable purchase price is critically important for financial security, and it is easy to let that number float up, up and away. We must draw the line somewhere or risk a cash flow crisis and possible bankruptcy (it happens). Owning a house you can’t afford is a good way to end up in the High Income / Low Net Worth category. If you are retired, the decision is even more critical.
Before we get started, make sure you know the following:
- Your current cash flow situation
- The terms of a new mortgage
- Closing costs
- Property taxes
- Estimates for changes to utilities, HOA and other expenses
- Expected repair/remodel costs for the new house
- If you are simultaneously selling a house, you need to estimate a range of sale prices, closing costs and moving costs.
I know this seems like a lot, but we are just winging it if we don’t know these things before making a decision.
Here are three rules of thumb that will help keep your expectations in line with reality. These rules should be true AFTER you purchase the new house, sell the old house, and move in. By the way, this is also useful for evaluating a big remodel project.
1) Maintained a cash reserve.
Your cash reserve should not be your down payment money. If you move into a house with drained bank accounts, you are asking for trouble. This means having at least $25k to $50k in cash after move-in for most households.
2) Maintained positive cash flow.
If you are living paycheck to paycheck in your beautiful new home, you can’t afford it. This is a common problem because 1) the new monthly bills are higher than expected and 2) new houses beg for runs to Home Depot and a new wish list of projects.
Not only should you have positive cash flow after you move in, you should still be able to save enough to build wealth and stay on track to independence. This means 15% to 25% of before-tax income for most households. (positive cash flow includes 401(k) savings, etc)
3) Did not rob the retirement nest egg or college fund.
If you had to liquidate your retirement account or use funds that were earmarked for the kids, you are probably overextending. The power of compounding growth is the greatest tool available to investors, and it requires money to stay invested continuously over long periods of time.
“But my house IS an investment!” It is common for folks to talk themselves into thinking of their residence as a retirement investment. This will be true if you downsize significantly in retirement and extract lots of cash from the sale. In reality, it is often the case that downsizing in retirement means fewer square feet, but a similar home value and little additional cash to spend. So is your house an investment? Kind of. It is a place to live 1st and an investment 2nd.
Another misconception is that home values offer attractive long-term returns compared to traditional stocks. There are definitely regional differences and market cycles, but the average home in American appreciates only 3-5% per year. The attractive returns in real estate are more likely to come from the combination of price appreciation AND positive cash flow from rental income. [Caution: generating positive cash flow from rentals is more difficult than it may seem.]
As mentioned, you can apply these same rules of thumb to remodel projects, but be sure to add 25% to the quoted price and 3 months to the timeline. I have seen plenty of skilled and knowledgeable homeowners run into nightmare contractors. That is a topic for another day.
– Kevin X. Smith, CFA
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