So you’re pre-qualified for the million or even multi-million dollar home, but should you buy it?
It can be tempting, and you might be able to afford it, but how do you really know? And how do you determine what the home purchase will do to your long term financial picture.
What Does It Mean to be House Poor?
According to Investopedia, “house poor” is a situation that describes a person who spends a large portion of his or her total income on homeownership, including mortgage payments, property taxes, maintenance and utilities. In other words, you’re house poor when your home expenses eat up all of your disposable income. You can afford the home, but just barely. Don’t expect to have the money to do other important things such as saving, giving, or traveling. If you’re not extremely frugal with your lifestyle, you may not even have enough to maintain the home.
If something goes wrong or lifestyle creeps up, you can quickly get into big financial trouble. Having no margin equates to major job dependency and few options for dealing job risks like burnout or unexpected career changes. For more on why margin is so important.
Today, mortgage lenders are happy to lend money as long as your Debt to Income “DTI” ratio stays below about 40-45%. Your DTI ratio is your total required debt payments divided by your gross (pre-tax) income. This debt total includes all debts such as student loans, auto loans, credit cards and mortgages.
With DTI ratio, the only considerations are income and debt payments. That should tell you something right there. It fails to consider other things like other home costs, home improvement, savings, giving, taxes, travel, and other spending. If you take out a mortgage that gets you to the max DTI, you’re going to be house poor. That’s why the lenders set this limit. House poor doesn’t mean you can’t afford the home. It means you can just by-the-skin-of-your teeth afford it.
I’m sure, if you are, or recently were a resident, you’re already used to living on the cheap. How bad can it be? Consider that living on the cheap in training when you’re single and renting a home is completely different from living on the cheap when you own a home and have a family. Homes are needy and more expensive than people think.
Families are expensive too. I’m sure you have competing interests that are extremely important that you might be overlooking. Before you pull the trigger on this, consider how much it’s truly going to cost you all-in. Also think about where it’s going to come from. When you’re upgrading your home and you’re income stays constant, the money must come from somewhere. You need to know ahead of time how you’re going to make it work.
First thing to consider is all the other home costs. Nice homes cost a LOT to keep up. If you don’t believe me, talk to anyone that’s reasonably financial savvy that’s owned a home for a really long time. Either they live in a dump or they’ve had to spend a lot maintaining their home. Here are what those expenses might look like (keep in mind these are baseline expenses which include maintenance to keep the home in the current condition):
Some of you are thinking maintenance is way too high. If you don’t trust my word, experts suggest setting aside 2 – 4% of the value of the home just to keep it in good working order. And this is before any upgrades or expenses like security systems, lawn care, landscaping, or HOA fees. This is bare bones – get you in the house and keep it in the condition you bought it. Nothing more.
There are different levels of house poor physicians. Let’s say a young physician is starting in practice at $250k/yr and is considering purchasing a $1mil home. They also have student loans and a car payment which totals $30k/yr. This would equate to a DTI of around 35%. You might think that’s fine and much better than the 45% max. However, when you carve out all the other baseline expenses, the leftover disposable income (before any extra expenses beyond owning the home + baseline necessities) is around $25k/yr. That’s not much considering it’s before any saving, investing, giving, travel and entertainment.
Maybe it’s not technically a house poor physician because there is some margin. But it’s not much, especially after all the hard work you put in getting to where you are today. I would consider this to be house poor if the house eats up so much of your cash flow that there is not enough leftover to really use money to live out your values. When the house gets in the way of you living a better life, that’s house poor. So how do you figure that out?
The Wrong Way To Determine Home Price
Most people ask the question, how much house can I afford at my income? This is the approach the lending and real estate industry use. This “debt first” approach is the wrong approach. The problem is it assumes that buying as much house as you can afford is the most important priority. But everybody has other priorities. And most people don’t rank their home as the top priority.
The Right Way To Determine Home Price
Think about your values first. What’s most important to you now and in the future? Consider how you’d like to prioritize those values and related goals and how the house decision stacks up against everything else. Think about the tradeoffs of buying more home vs. less home and where that money is going to come from.
Once you’re clear on values, goals and priorities, it’s time to get organized. You should have a good idea of what you own (assets) and what you owe (debts) and where you’re money is going each month (cash flow). Begin to model in scenarios that incorporate those values and the potential home decision. This will allow you to “balance the budget” of the potential new home expenses while considering all the other priorities.
Life is great when you can learn to use your money as a tool to live out your values. The home decision is such an important one because it can really make or break your ability to live out those values. Ideally, this new home brings you in even more alignment with your values. However, you have to be intentional about it. Going in off the cuff or using rules of thumb doesn’t cut it. Take your time and remember what’s truly most important.
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Wrenne Financial Planning is a registered investment adviser. The content of this blog post is intended for informational purposes only and is not intended to be investment advice. The views expressed in blog post are subject to change based on market and other conditions. Some information has been obtained/provided from third party sources and is believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.