The plunge

Buying a house is the ultimate human cocktail.

Emotion boils. Because real estate is a social marker, everybody wants some. Since most people are financial illiterates, property is the ultimate and only strategy. It’s the one asset the bulk of people even know how to buy. Culture factors in, too, creating an irresistible parental pull, despite the cost. Add in recency bias – we’re had a decade of house inflation, therefore people think it will rise forever. So greed looms large. Plus, the sheer ignorance of words like ‘rent is throwing away money’ are repeated, even as owners flush away fortunes in interest, property tax, insurance, repairs and transaction costs.

Real estate is the nation’s religion. It’s made some people considerable money. It has led millions into historic levels of debt. As house prices go up, our savings rate falls. Now the median nest egg of retirees without a corporate pension is merely $3,000, and their income under $30,000. They probably have a house, but the result is a few thin final decades of life.

Well, this blog won’t change the mentality of millions who think life’s goal is property. But it will always tell you to keep a balanced life. There is utterly no shame in renting. Only shame on those who make you believe so.

Thus, when it comes to that decision – usually faced in marriage – about how much house one can afford, confusion reigns. Even among the chosen few we know as blog dogs.

Like Chris:

My question is on the topic of what constitutes a reasonable amount of house to purchase? I know you’ve talked about your rule of 90, and buying if you can afford it, but there seems to be a myriad of different information/opinion about what “affording it” actually entails.

I’ve heard of spending 30% of your income on housing, but there seems to be no clear consensus on if that is gross income or net income? When I run the numbers with a handful of mortgage affordability calculators they tell me we can afford a house ranging from ~$970,000 all the way to ~$1,600,000. So I’m curious as to your opinion. What would be reasonable? A mortgage of 4x our household income? Spending 30% of our net income on housing? Or is there another way you recommend to assess reasonableness. The last thing I want is to overextend ourselves and be house poor. As always, very much appreciate you and your daily blog for all of the help and advice you provide.

Plus Adrian:

I’d really like to thank you for the daily dose of sanity. I landed in this beautiful country three years ago at 27 and have been reading your blog ever since. It is a breath of unbiased air with views on everything from dogs to macro economics.

Since you’re doing a piece on How much real estate you can afford tomorrow, I thought I’d write to you. That’s a question I’ve been mulling over for some time now.

Work in finance. Started at $60k but have worked my way up to a job that pays $150k a year including bonus. Wife (30) is employed as well and brings in about $50k a year. We’ve been renting a 1 bed room condo for $1,500/mo in the suburbs of GTA for over two years.  Over these years, we’ve maxed out our TFSAs at about $45k. I’ll be topping up my RRSP to $35k. In addition, I’ve about $65k sitting in cash. (I know I lost all your respect here)

Like any other immigrant, I’m planning to bring my parents here, start a family and get a bigger place. Any decent house I find is going for $750k-$800k even in the suburbs. The monthly carrying costs of these properties is going to be at least $3,500. I don’t plan on touching my TFSA. I can use $35k from the RRSP, $55k from my cash and the remaining $80k I can get as a loan from my family through their line of credit.

Now the ultimate question. How much can I really afford? I don’t want to jeopardize my finances and put all my money into four walls just so that I can call it my own when it actually belongs to the bank. One last thing, two years ago, I drove by the Belfountain store in the summer and saw you tidying the place up. Should’ve stopped and said hi but I was too reluctant. Biggest regret.

Well, gentlemen, there’s no single answer to this eternal question. It’s all a matter of how much risk you want to swallow, how much leverage you’re willing to shoulder, and what you think the benefit is from doing so. The economic answer is not the emotional one. Here are some considerations…

1. A house is not a financial strategy. You have no control over where the market goes. At some point in your life you may have to turn it into income. Trading a $1,500 rental for a $3,500 monthly nut – and a pile of debt – is a huge move, especially when it means you stop saving.
2. Have kids? Want them? After that decision’s made, family is your highest financial obligation. Children care not if you rent. But they do care if you can’t afford to help them get educated. Never buy a house because you’re pregnant.
3. Real estate costs a ton to buy and own. Far more than renting. Owners are gambling the asset will rise in value and cancel out those additional costs. This is a risk you must accept. Doesn’t always work out.
4. Understand the tax rules. If you flip, gains will be taxed as income. If you rent property out, profit will be taxed as capital gains. If you reno and lease a portion of your home, you could lose much of your tax exemption status.
5. The ‘how-much-can-I-afford?’ question is not just about cash flow. It’s about the future. Do not put so much into real estate that you can no longer save or invest. That is a total toss. Ultimately we all need income more than a roof.
6. Follow industry formulas for cash flow guidelines. The total debt service (TDS) ratio should be 42 or less. To calculate add all payments (house, car, loans, utilities, insurance, taxes) then divide by gross monthly income and multiply by 100. Rule of thumb – keep house costs to 30% of net income.
7. Don’t be fussed about paying off a cheap mortgage with money that can be invested for far greater growth. Almost all published advice is wrong on this point. In a low-rate world you’re better off to grow investment accounts and use gains to pay down a home loan principal upon renewal.
8. Adhere to my Rule of 90 for life guidance. The amount of total net worth in residential real estate should equal 90 less your age. That means young people can afford more leverage. Oldies should have way less. The rest of your net worth should be liquid.

The most important rule: stop emailing me seeking financial justification for something your spouse, your guilt, your mom, your friends or your hormones is making you do. I almost don’t care.