If you’re in the market for a new home, it’s easy to forget how the purchase might impact your other short and long-term financial goals. While you’re busy thinking about school districts and bedrooms and bathrooms, tunnel vision can set in—potentially compromising your overall financial plan.
If you spend too much money on a home, other financial priorities will likely suffer. But, if you spend too little, you’ll likely feel deprived—and perhaps have to move again in a few years, in search of more room or a better school district. Although there’s nothing wrong with buying a “starter home,” every move comes with transactional costs, and finding a place you’ll be happy in for several years is ideal.
To figure out how much to spend on a home, you first have to determine how the purchase will impact each of your short and long-term financial goals.
Professional advisers use a “values discovery” or “goals clarification” process to produce a prioritized list of all your financial goals and objectives. The list will clearly identify, rank, and assign both specific time frames and dollar amounts to each of your goals. With this in hand, it becomes easier to see where buying a house fits in.
If you’re like most people, your financial goals and objectives include some combination of the following:
Once your financial goals and objectives are identified and prioritized, it’s time to develop a plan. After running the numbers, you’ll typically find that funding every goal at 100% isn’t realistic. That’s okay. Your goals and objectives list is prioritized so that you have clarity regarding areas available for compromise.
Whatever your goals, you probably have one that trumps all others, even a home purchase: financial independence. In other words, you wish to reach a point when work becomes optional and you’re free to do pretty much what you want, when you want. It’s also the one goal that generally isn’t considered optional, given that you can’t work forever.
Although it’s hard to pin down exactly how much money you will need to be financially independent, a good guideline is to have at least 12 to 15 times your preretirement gross income accumulated in various investments by age 65. Fortunately, during a typical 40-year working career, accumulating this much is fairly achievable, assuming you save 12% to 15% of your gross income each year.
In simplest terms, when the dust settles from all the number crunching, you’ll generally find that you can afford any home that allows you to continue saving 12% to 15% of your gross annual income.
Like most financial questions, the right amount to borrow is largely a personal decision. That’s because managing debt (leverage) means balancing risk and reward—both of which everyone perceives differently. Further complicating matters is the fact that your tolerance for risk will likely change over time. The mortgage you’re comfortable with at age 40 will likely be different at age 60. A good general rule is to limit mortgage debt to around 1.8 times annual gross income at age 40, decreasing to .7 by age 60.
Keep in mind that, from a sharp-pencil perspective, mortgage questions should take into account whether you can earn more on your outside investments than the mortgage costs you. The basic idea being, if you can earn a higher rate of interest elsewhere than what you’re paying on your mortgage (factoring in other costs and tax implications), keep the mortgage and let your investments run.
However, you aren’t a robot, and you’re entitled to your feelings about debt. As a wise financial adviser once said, “If a client asks you whether he should pay off his mortgage, and you break out your calculator, you’re about to give bad advice.”
Advisers know that buying a home can be pretty emotional. They also know that emotion can be expensive if not properly managed. To help keep your emotions in check when buying a home, advisers will often recommend you consider how the purchase will impact your journey from being a supplier of labor to being a supplier of capital (to other suppliers of labor).
You obviously need a sanctuary in which to recharge yourself every day during the years you’re busy plying your trade or wares, but a home that extends your plying years for too long is the wrong home for you. The right home will facilitate your transition to financial independence right on time.
Not surprisingly, when working with clients, I’ve noticed that the home-buying decision is largely driven by how they feel about their career. For those looking to escape their job, once they see the number of additional years they’ll have to work by spending at the top of their budget, reality sets in and certain “must-haves” quickly become “nice-to-haves.”
If you’re fortunate enough to be fairly indifferent regarding when you’d like work to become optional, you might be able to spend on a home more freely. However, don’t go crazy; suppliers of labor haven’t fared as well as suppliers of capital in recent years, and that trend doesn’t appear to be changing.