When it comes to purchasing a home, most people start by asking their mortgage broker or loan officer how much they can afford, then they immediately start house hunting. This approach not only risks letting others dictate how big of a home you’ll end up buying, but also having someone else leave a lasting impact on the other areas of your financial life.
Taking a holistic approach to buying a home by factoring in all of your financial goals (retirement, sending kids to college, starting a business, etc.) will ensure it is the right home for you, not just the largest or most expensive one you can afford.
Start the House-Hunting Process With a Budget
The first step to developing a projection model would be to look at your current spending and savings patterns. Apps like Mint.com are great tools to quickly auto-generate a budget and get a detailed report of where your money goes according to category (food, transportation, rent, utilities, etc.). You might be tempted to strip out one-off expenses like a weekend holiday or going to a friend’s wedding, however, you’re likely going to have some sort of “one-off” expenses every month for the rest of your life, so looking at the last 12 months of data will give you a better idea of real spending patterns.
Estimate your annual savings and the cost of your goals. Once you know where all your money is going, separate how much money is going toward savings every year in all of your accounts (checking, savings, brokerage accounts, 401K, etc.).
Determine Long-Term Financial Goals
Once you understand your annual budget and savings patterns, start defining what your long-term financial goals are and estimate what they cost. The most common goals would be saving for retirement and saving for your children’s education. Given that expenses tend to increase every year, don’t forget to account for inflation.
For example, if you are spending $80,000 annually today at age 35, you’ll need $167,000 annually at age 65, assuming a 2.5% inflation rate. Build your projection model. This will involve a bit of spreadsheet work. You should project the amount of savings each year over your lifetime and the earnings rate on those savings to determine if each of your goals has been funded. (For related reading, see: Curbing the Effects of Inflation.)
Project Mortgage Payments
Start with projecting mortgage payments equal to your current rent, then add in your down payment. If the projections show you are on track with your savings with some cushion, then you can afford to take on a higher mortgage payment. If you aren’t on target yet, perhaps you should take on a smaller mortgage to increase your savings rate.
Many people look at the after-tax mortgage payment for projections, but this can be problematic. Each mortgage payment is part interest payment and part principal payment. As time goes on, your interest deduction decreases over time, as principal payments become a larger and larger part of each payment. It’s also possible that the mortgage deduction could be partially or fully eliminated by Congress in the future. (For related reading, see: Tax Deductions on Mortgage Interest.)
Run Different Scenarios
Projections can be very useful, but life can be unpredictable. Run various scenarios: What if you or your spouse lost your job for six months? What if you had to retire earlier? What does this do to your retirement projections? How would $100,000 more or less in a mortgage affect reaching your other goals?
Projections are only as good as their inputs, but projections can be helpful in making important life decisions and can be helpful in understanding the trade-offs of certain decisions. For example, the projection model might show that buying a home that’s $900,000 instead of $700,000 would mean working until 67 years old instead of 65 years old. A properly built projection model can help illustrate those trade-offs right away. (For related reading, see: Mortgages: How Much Can You Afford?)
Having the Right Size Home for You
Buying the right sized home can mean a world of difference in terms of making the right financial decision for your family. If you do end up with a home you can’t afford, you could be saddled with ever-increasing expenses such as utility bills, real estate taxes, insurance costs, lawn care, repairs, the list goes on.
What can you do if you already have a house you can’t afford? There are really only three options: spend less, make more or sell the house. A lot of us have been told to stretch and buy the biggest house we can afford so we can downsize in retirement and make a profit when we sell our home. Your house should never be your retirement plan because this can easily backfire. Downsizing in retirement usually doesn't work out like people envision it will. Convincing your spouse you need to sell the house and move to a different neighborhood can be hard to pull off. As well, selling the house at the onset of your retirement could coincide with a down market.
When determining how much you want to pay for a home, a properly built projection model can avoid bad real estate decisions and keep you on track to achieve your financial goals.
(For more from this author, see: 7 Ways the New Tax Law May Impact You.)
Disclosure: The information provided through this communication is intended solely for the general knowledge of visitors and does not constitute an offer or a solicitation of an offer for the purchase or sale of any security.