How much you should spend on your next house

The banks will tell you how much you can borrow. But how much should you really borrow? This article describes how to estimate the ideal maximum amount you should borrow and the true maximum affordable repayment. Follow this process so you can avoid over-extending yourself and find a harmony between lifestyle now and your future lifestyle.

These days I rarely read a non-fiction book cover-to-cover, instead I flick through to grab key ‘big ideas’ to evolve my thinking. In the past year one book I delightfully read in full was “Predictably Irrational” by behavioural economist Dan Ariely.

As I immersed myself in the insights there was one in particular, right at the very end that I read as a personal challenge. (page 285, 2009 revised edition, pbk)

Dan Ariely described how when he and his wife Sumi went to buy a house he asked some experts he knew “including a few finance professors from MIT and investment bankers” what seemed to him like a simple question.

It is a question you have probably considered too.

“How much should I spend on a house?”

Ariely describes how everyone told him the same thing – a way to calculate how much he could borrow based on his income and the interest rate. But that’s not the question he asked.

Ariely noted “when I tried to push for an answer, the experts told me that they had no way to help me figure out the ideal amount we should spend and borrow.”
(my emphasis)

Can you see why I read it as a challenge?

Well, I have the answer for you Mr Ariely (I hope one day I can call you Dan).

First, let me share Ariely’s behavioural conclusion from his experience:

“When we can’t figure out the right answer to the question facing us, we often figure out the answer to a slightly different question, and apply this answer to the original problem.”

Hopefully you can see the potential issues in that human decision making.

How much you should spend on your next house

The maximum price you should pay for your next house is the sum of:

  • Your saved deposit
  • Transaction costs
  • The maximum amount you should borrow

The maximum amount you should borrow is a function of:

  • the loan term
  • the average interest rate over the loan term
  • your maximum affordable regular repayment amount.

For definitions of the categories described in the formula below see my ‘Pay Yourself First (in practice)’ model I described in my recent article on better budgeting.

Maximum affordable loan repayment equals your net after-tax income, less allocations for:

  • Regular saving for your financial independence goal
  • Regular saving for pre-retirement essentials
  • Repayment commitments on other existing debts
  • Irregular expenses
  • Regular essential and comforts
  • Impulses and indulgences (presuming you’ll still want the occasional splurge)

Now you have estimated the ideal amount you should spend on repayments rather than some alternate rule-of-thumb like 30% of your income.

To estimate your maximum affordable loan amount you then plug that repayment amount into the free borrowing calculators provided by the lenders. Or you can do it yourself in a spread sheet using the present value (PV) function.

You can download an example calculation here.

Extra tips

By the way, don’t use what the lender says you can afford to repay each period. Their calculation ignores your need to save for eventual retirement and often assumes you can live a lifestyle equivalent to the Henderson Poverty Index (in Australia).

In completing the affordability calculation I recommend you:

  • Choose your loan term to match the amount of years until your financial independence goal. That way your debt will be repaid by ‘retirement’.
  • Add an extra 1% to the lender’s current interest rate to give you a buffer.

When you actually apply for the loan you can apply for the typical home loan term of 30 years and just plan to make extra repayments in line with your calculation. This technique also builds your buffer for if misfortune strikes.

In practice

Life is a balance between doing something that brings us immediate fulfilment and doing something else that is an investment in future fulfilment.

Exercise, healthy eating and study are often investments in future fulfilment.

If the type of home you really want to buy costs more than the above estimate you then need to make an informed trade off.

Are you willing to cut other elements of your current lifestyle? Or are you willing to cut your expectations of future lifestyle like holidays, car upgrades and retirement?

Please share your thoughts

What do you think of my recommended approach to this common dilemma? Please share your reflections in the comments below as I’d really like to know. (You can share under a pseudonym to protect your privacy.)

Author: Matt Hern

Certified Financial Planner professional, Matt Hern has three times been awarded as one of Australia's Top 50 Financial Planners by The Australian Financial Review Smart Investor. He is passionate about guiding you on the right financial choices to achieve what you really want. Matt Hern is an Authorised Representative of Charter Financial Planning Limited AFSL 234665. All information is general advice only.

2 thoughts on “How much you should spend on your next house”

  1. Matt,
    Interesting reading as always!
    One additional concept that I’d like your thoughts on is factoring in what level of debt you feel “comfortable” with. I know this intangible idea isn’t easy to apply a mathematical equation to, but is equally important in deciding how much money to borrow. Sometimes, this comfort factor is determined by unknown risks, such as dropping to a single income, potential increases to our expenses or external factors such as interest rate hikes.
    Another thing I know I struggle with is moderating my expectations for my own personal home to ensure that my long term goals of financial independence are kept in sight.
    Some food for thought!
    Cheers
    av

    1. Hi Avril and thanks for sharing your thoughts.

      Your second observation is precisely why I recommend people follow the above approach to estimating how much they should borrow. It keeps the long term financial independence goal in sight and part of the house buying decision. Playing with the numbers should make it obvious to people that if they buy a more expensive house they are choosing to delay and/or lower their retirement goal.

      Now onto your question about comfort.

      Yes, intangibles like comfort can’t be modelled – they are part of the magic that a professional like a financial planner brings to how you apply the formulas to your personality.

      Regarding comfort let’s discuss two scenarios – you could be comfortable borrowing more than the formula’s outcome or you could be uncomfortable borrowing even that much.

      You may be comfortable borrowing more because you’re willing to ‘bet’ that your future will be full of fortune such as promotions, bonuses and other financial windfalls. This good fortune, if it occurs, could enable you to play catch-up on the wealth creation you compromised by borrowing a higher amount.
      Alternatively you may be uncomfortable borrowing as high amount as the formula suggests you could afford to. That’s fine. You would end up spending less on the house and therefore potentially be in a less desirable property (based on size, location or other factors). If however the less expensive property meets your desires then woo-hoo you can now spend more on other lifestyle goals.

      If you’re uncomfortable because you’re wondering what to do if misfortune strikes then you need to implement safety nets at the same time as getting the loan. Erect safety nets to protect you against the events that concern you. Often the risks actually aren’t ‘unknown’. The consequences of each event can be imagined in advance as part of the planning process. It is just their occurrence that is uncertain. Sometimes their likelihood of occurrence can be estimated and that influences our decisions on what risks to manage. Later I’ll write a more comprehensive article describing the process of assessing what risks to manage.

      Common safety nets I’d recommend at the same time as getting a home loan include doing your calculations based on a higher interest rate (as mentioned in the article), building insurance, personal insurance, contraception and relationship counselling (divorce and unplanned pregnancy are costly).

      If of course you have intentions to potentially go to a single income you factor that in to the formula in the first place. You do this by either calculating on a single income or including an extra savings plan to fund the years of single income.

      Does that help? Let me know.

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