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.)

You may also enjoy these related articles:

1. Increase your cash flow by managing your debts
2. Qn: How do we get out of debt?
3. Six tips for choosing the best home loan

(Recorded 3rd July 2008.)

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You give up flexibility for certainty plus you often pay more.

 The initial attraction to fix rates is often primal – we hate to miss an opportunity to save money. With more rate rises forecast that’s precisely what people think they’ll be doing if they fix rates.

Most get it wrong

The reality is somewhat different for most. Research has shown that over half of people who fix their rates end up worse off financially. They pay more interest and repayments than if they’d left their loans variable.

For a personal illustration of that just ask anyone who fixed their rates two years ago when there was still talk of rates going higher. That crystal ball was clearly broken.

The Rate You’ll Be Paying

One belief is that you can fix your rate at the current variable rate, so as soon as rates go up you’re in front. That is not the case. Fixed rates are set taking into consideration the lender’s forecast of rates during the fixed period.

The following table summarises rates as at 7th November 2009 from the four biggest lenders:

Source: Cannex

Ponder This: If you fix your rates now how high do variable rates need to go before you break even overall?

For and Against

Why Fix

• You can’t keep food on the table if your repayments go much higher
• Your mindset is that certainty is a very high priority. (Any control freaks reading this article?)

Downside Trade-offs:

• You immediately pay a higher interest rate and higher repayments, which impacts your cash flow
• You are very restricted on the amount of additional repayments you can make, meaning you can’t ahead as quickly as you may like.
• There can be a break fee if you need to refinance during the fixed term (usually when your fixed rate is higher than the variable rate, like now.)

Things To Consider

What are your life plans over the next three or five years?

Your financial decisions today impact on the options you will have available to you tomorrow, next year and five years from now. If you’re not well informed some decisions you make can shut out important life choices you would like to make in coming years.

For example, let’s say you plan to upgrade your home in the next few years. If you have a fixed rate you may be liable for a large break cost. At the time the cost may be so high that you can’t afford it and end up not being able to move as desired.

Maybe you don’t plan to for certain, but maybe it’s an above fifty percent possibility. If so, wouldn’t you like to keep the option flexibly open to you?

Before fixing your rates write down all the things you think you may like to do in the coming years. Project out as far ahead as the period for which you are planning to fix your rates.

Pay rises

Right now you may not have the cash flow to make high additional repayments but keep in mind the pay rises and bonuses you may receive over the next two to three years. Wouldn’t you love to be able to use them to nail your mortgage?

Cash flow control

Remember that if your cash flow is hyper-sensitive to increased repayments then fixing rates will immediately increase your pressure. Instead, over the next few months redirect that same amount into getting some cash flow coaching. You’ll discover ways to save money that’ll actually decrease your sensitivity to rate rises.

Call or e-mail me now to enquire about my Cash Flow Coaching program.

Still Unsure?

On thing you can do is hedge your bets by splitting your loan into a variable and a fixed portion. It doesn’t need to be an even split.

If you’d like some assistance in making the decision then book a meeting with me. I’m confident you’ll have a clear decision in under an hour.

Please Share This

If you found this article to be useful please forward it to your friends who have mortgages.

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1. Is now the time to fix interest rates?
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Let us remember this is the lowest interest rate in over 30 years. Rates are artificially low to stimulate the economy short term. This is not normal or even an average.

So it is fair to assume that over the 25 to 30 year loan term that interest rates will go up again. If you can’t afford the repayments when interest rates go back up (as they will) then buying a house now is a recipe for future financial stress.

The current interest rate only makes a home more affordable if you can fix your rate at current levels for 30 years.

If you still buy even though you can only just afford the repayments now then you are betting that your income will increase quicker than interest rates. Start praying that it does.

The only thing that makes the house more affordable is free cash in the form of the First Home Owners Grant.

House prices will perhaps stop decreasing so rapidly. Lower interest rates reduce the pressure on would be sellers so they will be less inclined to drop the price of their house. It is suddenly more affordable for them to hold on.

Of course you could be really creative and just buy a less expensive house that you could afford.

TIP: calculate your affordability based on the repayments if interest rates are 3% higher than they are at the time of purchase. Then make repayments at that level right from the start.

You may also enjoy these related articles:

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2. I’ll huff and I’ll puff and I’ll…
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Here are Damian’s Six Tips:

Tip 1: Be clear on the purpose of the finance

Gone are the days when there were only a few types of mortgage structures to choose from. Now there are lots of products for all the different ways people use their money. So before speaking to a lender be clear on he purpose of the finance you are seeking. For example, is your purpose buying a new home, building, renovating, car, holiday, investing, or bridging several of the above?

Consider not just your immediate purpose but also what may happen in the foreseeable future (say 3 to 5 years).

Tip 2: Make your finance as flexible as you

Our lives change rapidly these days. We change jobs, get married, start families, move suburbs, cities, states, start businesses, buy investments all within short spaces of time. (Or is that just me?)

Over these lifestyle changes, your cash flow needs change quite a bit too. So it is important to ensure that your finance is structured with the amount of flexibility you require. Consider:

• Is there a limit to the amount of additional repayments?
• Can I access my extra repayments if I need to?
• How easily can I refinance the entire arrangement?
• Can some of the overall loan be fixed, variable, interest only?

Tip 3: Cheapest is not always the best

Tip 3a: Beware hidden fees

Years ago when the regulations on calculating comparison interest rates were introduced it was a good system. But, the lenders have since worked out how to charge you fees which are not required to be included in the calculation of the comparison rates. This makes the loan look cheaper than it really is.

Some hidden fees to be wary of include:

• Exit fees on early repayment
• Restructure fees
• Lump-sum payment fees

Tip 3b: Consider the non-financial features

The money that is lent to you generally costs all lenders about the same amount. So the only way lenders can offer cheaper deals is by being more efficient or cutting out services.

Your loan may be cheap but come with no branch network, no relationship manager who cares about you, only a 1300 phone number operating on east coast time zones and limited transaction facilities. If any of those services are important to you it may be worth paying for them.

Tip 4: Ask for a package deal

Years ago these were called “Professional Packages”, but lenders have smartened up and now offer package deals based on your income and total amount borrowed. Under such deals you pay an annual package fee of around $295 to $400 and receive:

• Low (or zero) annual fee credit card
• Deferred establishment fees
• No loan ongoing fees
• You can split the total mortgage often into up to 5 parts to tailor each loan to be as flexible as your life.
• You receive discounted variable rates, and sometimes also discounted fixed interest rates

You can access such packages with an income of around $60,000 per year and/or total amount borrowed of around $150,000. These days most mortgages are for at least that amount, so almost everyone is eligible. You just have to ask!

Tip 5: Negotiate and shop around

Lenders DO negotiate! Branch staff may tell you that it is “policy” not to negotiate. They also may not even offer you the best product from their own company. That is because, in general, they are not rewarded for winning your business and making you a happy, long-term customer. They are paid mostly (or wholly) as salary.

So be prepared to shop around to get the best deal because in Damian’s experience the lenders do negotiate most often. Well they certainly do when a mortgage broker is involved!

If you’ve enjoyed these tips and need finance you can contact Damian Day of Ardent Mortgage Services on 0409 950 975 or by e-mail at .

You may also enjoy these related articles:

1. 3 tips to manage your mortgage stress
2. Increase your cash flow by managing your debts
3. How much you should spend on your next house