Let’s say you’re in the market for your first house. Thanks to family support and your own frugal lifestyle spending, you’ve managed to accumulate $600K for a down payment. After searching for months you discovered a fixer-upper in the suburbs for $1 million (after all, you’re in the Bay Area). The real estate agent recommended a lender who is willing to provide you a $400K loan. You’re ecstatic and ready to sign the paperwork.

What’s wrong with this picture?

Let’s examine how you got to this point. Lenders utilize several debt-to-income (DTI) ratios to determine the maximum amount they are willing to lend you and the interest rate they will offer. One commonly-used one is a comparison of your monthly house payment (including principal, interest, taxes, and insurance) to your monthly gross income. They generally restrict this ratio to be 28% or less. As an example, let’s assume your monthly gross income is $10,000. Therefore the lender would limit your monthly mortgage payment to $2,800. If prevailing interest rates and your credit score enables you to qualify for a 30-year loan at 6%, the maximum loan amount would turn out to be a little over $400K. So in this example, it sounds like everything is perfectly lined up for you to buy this house.

However, the analysis above wasn’t designed to help you figure out how much house you can afford. Its purpose was to help the lender mitigate the risk they are taking for loaning you the money. In other words, it was for their benefit, not for yours. You’re now on the hook for those mortgage payments for the next thirty years. You might run into a cash flow problem in the future, perhaps from a lifestyle change due to marriage, divorce, children, job change, medical problem, whatever. What if it turned out that the only way you could continue to pay the mortgage five years hence was if you had to give up dining out, your SF Giants season tickets, and the school trip to Washington D.C. that your daughter had been looking forward to for months? You will have become what is called “house poor.” How would that affect the quality of your life?

The true effective way to determine how much you can actually spend on a house – not how much a lender is willing to lend – is to create a financial plan before beginning your home search.  A good plan will take into account your cash flow, the other goals in your life for which you will be spending money in the short, medium, and long-term, your retirement expectations, your current savings, and your expected future savings. From that data the amount you can afford to spend on a house can easily be determined. You can even compare various mortgage and/or lifestyle options to see which one would be optimal. What makes this approach so beneficial is that it will change the context of the house purchase decision from “how much can I borrow” to “how much I can afford to pay back while leaving myself enough money to be able to do everything else I want to do for the rest of my life.” 

Neither real estate agents nor mortgage brokers are in the business of creating financial plans for their clients. You can either do it yourself or hire a Certified Financial Planner™ professional to do it for you. Either approach will take time and involve costs. Is creating a financial plan worth doing? Ask yourself which would be worse: to discover that you cannot afford a house before you buy it? Or afterwards?

(PERIGON is a registered investment adviser. More information about the firm can be found in its Form ADV Part 2, which is available upon request by calling 877-977-2555 or by emailing compliance@perigonwealth.com).