How much debt should you take on to buy a house?
Lenders will lend you as much as you can pay. They don’t care what you have left over to live on after you’ve made your mortgage payment. All they care is that you’re able to make your payment. That they will get paid.
You, however, need to consider not just what you’re capable of paying on your mortgage, but how much you can pay when you factor in all the other costs of life—including funding your retirement.
The size of your mortgage should be determined based on your after-tax, after-savings income. In other words, after you’ve paid tax on the income you’ve made, and you’ve set aside at least 10 percent of your income for retirement and have some money for living, how much do you have left to pay towards your mortgage? That’s how big your mortgage should be.
Financial experts have long recommended this be 30 to 40 percent of your gross income—that your mortgage payments, and other housing costs including property taxes, property insurance, etc., make up 30 to 40 percent of your gross income. This leaves room to save at least 10 percent of your income for retirement, pay income taxes, and live life. If you go above this, you’re squeezing something out. And I can tell you, it won’t be income taxes!
In the book The Millionaire Next door the authors suggested the following:
If you’re not yet wealthy but want to be someday, never purchase a home that requires a mortgage that is more than twice your household’s total annual realized income.
I recognize for a new homeowner today this is virtually impossible. The median household income is roughly $100,000 and the median house price is about $750,000. That means the median house price to income is 7.5x. Much higher than the recommended 2x in The Millionaire Next Door. The world has changed since that book was written in 1996. What hasn’t changed is the importance of keeping your housing costs in check if you want to build wealth.
So What Should You Do?
Try to stick to the suggestion of not spending more than 40 percent of your gross household income on housing costs. If you can do that, you will leave room to save money for retirement and live. Do the best you can to hit that target. It leaves a margin of safety, and will reduce stress in your life of having housing costs consume too much of your income.
Building up savings and paying down your mortgage and building equity in your home builds both sides of your household balance sheet. It increases your assets—your investments and equity in your home. And reduces liabilities—your mortgage. You can’t help but make financial progress doing this. And it diversifies your assets, across categories and time.
If you don’t own a home but rent instead, make sure you continue to build up your assets. Don’t let your money slip through your fingers. Make sure you set aside the money that would be going into a home into investments instead. Not being required to make mortgage payments means you need to be extra disciplined with your savings. Automate them, have them come directly off your paycheck, to make sure your money gets invested.
Interest Rates
Interest rates are a hot topic lately. Considering how low they’ve been over the last decade, where they’re at today seems high. But historically, they’re not. They’re right around the average they’ve been over the past century. The past decade prior to Covid was an anomaly. They got dropped to the floor to respond to the financial crisis in 2008-09 and were probably left too-low for too-long. Covid and the inflation that came with it brought them back up off the ground. And there’s no guarantee that they’re headed back down to where they were. In fact they likely aren’t, baring another financial crisis.
In all likelihood, rates head down a few percentage points from where they are today once the economy and inflation cools, but I wouldn’t count on them going back to where they were before Covid.
Mortgage Payments
When you pay down your mortgage, look at it as getting a guaranteed rate of return on your money. If the interest rate on your mortgage is 5 percent, every time you pay down your mortgage, you’re getting a guaranteed 5 percent rate of return on your money that goes to paying down the mortgage.
Putting extra money towards your mortgage to pay it off quicker could make sense. You get the guaranteed rate of return. You also get peace of mind knowing that the liability side of your balance sheet is shrinking.
I don’t think you should throw all of your savings at your mortgage. You want to build up the asset side of your balance sheet, diversifying away from real estate. But it doesn’t hurt to throw some extra money at your mortgage, particularly if the prices of other assets, like stocks, are high.
Fixed or Variable
Those who had variable rate mortgages have made out well over the past 40 years, as interest rates have steadily headed down from their peak in 1981. But when rates are low, does variable still make sense? It depends on where rates are headed. In hindsight, in 2020-21, it made sense to lock in at ultra-low rates, as rates have risen significantly since then. What makes sense today? It depends on where rates go, which no one knows for sure. I would say the odds are more likely today that they head down from here, particularly if the economy softens. But there are no guarantees. I think you should go with whatever mortgage you’re most comfortable with. If fixed provides peace of mind, go with fixed. If you’re comfortable with the fluctuations of variable, go with variable. Each have their pros and cons.
Things Change
The other thing to keep in mind when taking out a mortgage is that your life may change in ways that you’re not expecting. For instance, you may move into your house with you and your spouse working. That may change if you have kids. One of you may stop working, at least for a period of time, which may effect your income and your ability to make payments. Try to plan for this as best you can. It’s another reason not to stretch yourself too thin and leave a sufficient buffer in place.
Keep Debt to a Minimum
With regards to non-mortgage debt, you want to keep it to a minimum. Use a line-of-credit only as a lifeline. Too many people use it as a credit card. Interest payments on them can be steep. Don’t be tempted to dip into them, or to tap the equity in your home, unless you need to. Same goes for tapping your other investments.
Also, don’t carry a balance on your credit card. This is a cardinal sin in personal finance. Pay it off entirely each month. The interest charges will eat you alive. They are compound interest in reverse. As Einstein said about compound interest, “He who understands it, earns it. He who doesn’t, pays it.” Make sure you earn it and don’t pay it. If you’re having trouble paying off your credit card in full, you’re best to cut it up and pay cash, forcing yourself to spend only what you have.
Hurt So Good
Even if you are able to pay off your credit card in full, understand it can still hurt you financially, if it prohibits you from saving what you otherwise could and should. Credit cards make purchases very convenient, which is both a blessing and a curse. If you’re not hitting your 10 percent of gross income savings target, I would consider cutting your card until you can hit that number. Something about feeling the pain of paying cash makes it an effective financial tool, especially for those who have difficultly controlling spending.
The Real Benefit
The real benefit of not having consumer debt is that it let’s you sleep better at night—it reduces stress. Debt is like an anchor. A ball and chain. You’re not truly financially free until you’re unshackled from that chain. Eliminating consumer debt empowers you.
Even better than paying down your mortgage, if you pay down consumer debt that charges 10 or 20 percent interest, you’re making that rate of return on your money—guaranteed. You will not find this rate of return on any other investment consistently. You’re best to pay down consumer debt first, before doing anything else with your money.
Good Debt
Remember, good debt is this: debt taken on to buy an appreciating asset, where paying it off doesn’t squeeze out savings, and that will be retired before you are.
Bad Debt
Bad debt is everything else.
If your debt prohibits you from living and saving your money sufficiently, it’s bad.
Bottom Line
Don’t take on as much debt as lenders are willing to lend you. They don’t care about your life. They care about getting paid.
What you need to care about is:
Saving for retirement
Saving for other things
Having a life
Any debt taken on needs to enable these things.
Use debt wisely and sparingly and you will flourish financially.