What you can afford has little to do with what a mortgage broker will lend you for your house…. Just because you take out a mortgage for 20% less than the maximum amount the bank or mortgage broker is willing to loan you does not mean you are being financially prudent – 20% less than lunacy is still lunacy. – Ronald T. Wilcox, professor of Business Administration at the University of Virginia’s Darden School of Business.
Owning a home is “the American dream” and is a worthy goal. For most of us buying a home will be one of the biggest financial decisions we make, so getting it right is vital.
Since almost everyone will have to take out a mortgage to afford a home the important question is “How much should I borrow?” The last thing you want to do is take out a mortgage that makes you “house poor,” meaning you are not able to afford other important priorities – things like enjoying the present and saving for the future.
Don’t Trust the Bank to Tell You What You Can Afford
So how much should you borrow for a home? If your first thought was to just let the bank tell you how much you could afford, hit yourself in the forehead like an actor in one of those V8 commercials.
If we learned anything from the recent housing crises, where banks routinely made loans that people had no chance of paying back, it is that you cannot trust financial institutions to look out for your best interest. While lending standards have become more realistic since the crisis you still need to do your own analysis, and not rely on self-interested financial institutions to give you good advice.
The “Millionaire Next Door” Rule of Thumb
So if you can’t rely on banks to tell you how big a mortgage you can afford, how do you decide? I like the rule of thumb suggested by Thomas J. Stanley and William Danko in their book The Millionaire Next Door, in which they state, “If you’re not wealthy but want to be someday, never purchase a home that requires a mortgage that is more than twice your household’s annual realized income.”
This means if your household income is $50,000 per year you should not take out a mortgage for more than $100,000. This is a conservative standard, and sticking to it might mean putting off a home purchase until you save more for a down payment, but it would definitely keep you from becoming “house poor.”
Speaking of rules of thumb, Nassim Taleb reminds us that they “make things simple and easy to implement. But their main advantage is that the user knows that they are not perfect, just expedient, and is therefore less fooled by their powers. They become dangerous when we forget that.”
In other words, while I like this rule of thumb we need to remember it is only a guideline. Also, this rule doesn’t take into account current mortgage interest rates, which are still very low. In a period of low interest rates you could safely borrow a bit more than twice your household’s annual income and still comfortably afford the payments. An even better move would be to stick to the guideline and take out a 15-year mortgage instead of a 30-year mortgage.
At any rate, I like this rule of thumb as a starting point in your house shopping adventure rather than using the amount the bank “pre-approves” you for. Shooting for a mortgage that is less than twice your household’s annual income will anchor you to reality while providing a little wiggle room if necessary. Have fun house shopping.