The million dollar question that every Millennial wants to know is “how much house can I afford?” That’s because despite the high prices in two of Canada’s major cities, the majority of Millennials still want to buy a home. With house prices rising much faster than income in their respective cities, just how much can the average new professional afford when getting their first job?
Everyone’s heard the common phrases of “why pay someone else’s mortgage?” or “you are just throwing your money away” but a lot of those myths were debunked in my previous post. Buying can cost just as much or money than renting. So when it comes to buying, it’s all about the lifestyle choice. If it costs just as much or more to buy, then the money part of it goes away. Like any other choice we make like buying a BMW or Corolla, or buying an LV bag versus a Guess bag, it’s all about the lifestyle choice we make.
Buying a house is no different nowadays. It’s an expense that defines who you want to be and what you want to devote your finances to. The key part of buying a house is understanding just how much you can afford. The worse thing you can do is make yourself house poor or over stretch your finances to the point where it gives you undue stress.
The Old School Saying
There’s been this rationale that’s been around forever where pundits say that you should only buy a house where the cost of the home is only 3x your gross annual income. This was a ratio that was used back in the day when home prices were reasonable. It’s also very similar to the P/E (Price to Earnings) ratio that stocks are gauged by.
In today’s low interest rate environment, this rule can almost be thrown out the door because it doesn’t work. In fact if you look at the ratio of home prices to annual salary in cities like Vancouver and Toronto it’s ridiculously high!
Back in the hey day when prices were reasonable, this was a good measurement because it almost meant that, if needed, home owners could save aggressively and pay down their mortgage in less than 10 years. This meant it was possible to get mortgage free before getting to your 40’s!
The same can’t be said for those who want to purchase in 2018. House prices are expensive, and if you live in one of the large popular cities in Canada the 3x salary just isn’t going to work if you want to achieve home ownership. That’s why it’s important to know, that buying a house in an expensive market means you are committing yourself to home ownership and the responsibilities that entails for more than 10 years. Hey, it’s a lifestyle choice remember?
This rule was widely used in the past, but it certainly doesn’t say anything more than how fast you can really pay off the home. It doesn’t really compute cash flow on a monthly basis, so in essence it’s a very raw value to look at when trying to determine if you can afford a house.
The Rule of 15
Another popular ratio that people use is called the Rule of 15. This rule was developed more for investment purposes, but is widely used to make claims of renting versus buying.
The rule worked by looking at how much annual rent for a similar popular might be and then multiplying by 15. If this number was greater than the purchase price of the house, then buying would be better. Conversely if the number was less than the purchase price of the home then it would be better to rent.
As an example let’s look at an example in one of my previous posts:
- To rent a 1 bedroom in Toronto, it will cost $2,200/month
- Multiply $2,200 x 15 = $360,000
- Now compare to similar condo prices which are selling for $575,000
Based on the example above, $360,000 is less than $575,000 so it would be much better to rent versus buy.
- Purchase price / Rent per month / 12 > 15: Rent
- Purchase price / Rent per month / 12 < 15: Buy
Again these are all based on investment numbers and doesn’t really say anything about the cash flow or behavioural side of things. When looking at these raw numbers, it really only tries to determine whether from an investment and money standpoint, whether it’s a good idea to buy. It doesn’t actually say anything about whether the monthly payments can be affordable.
The rent versus buy ratio was really meant for investors to determine whether to put money into rental stock or apply the money to other investments. Since interest rates are so low right now, this rule has been completely skewed. It’s not uncommon to see price to rent ratios for Toronto or Vancouver in the 30’s.
When you go to ask the bank for a mortgage, the first thing they will try to compute is how big a mortgage you can afford. That’s because the bank carries risk when they lend money out to the home buyer.
The bank will use the standard percentages. No more than 30% of gross income per month should be used towards mortgage payments, property taxes, maintenance fees and utilities. This means if you make $60,000 yearly, the the bank will assume you can only spend $1,500/month on housing costs a month.
However, there are exceptions that a bank is willing to make in order to get you into your house. If your credit history is in good standing and you don’t have much debt, the bank could go further and use the Total Debt Service of 40% instead. This gives a $60,000 earner an extra $500 to get up to $2,000.
It wouldn’t surprise me for cities like Toronto and Vancouver, that the banks are willing to push the Debt Service percentage closer to 50%. With prices so high, it’s almost impossible to buy a house without giving half your wage away, but the banks don’t care. They know they can profit from taking as much money from the home buyer as possible every month.
There’s one thing to note about a bank though. They are out there to make money and the home buyer is the most lucrative business there is. Even if the the bank is willing to offer you a huge mortgage amount does not necessarily mean that it’s affordable. The bank wants you as a customer, so that they can collect interest payments from you for the next 25 years.
That is why you should never trust your mortgage broker or your bank. They want you to maximize your mortgage amount. This assures them the best profit margins and at the same time it has the negative affect of constraining your cash flow from month to month.
My favourite rule for home affordability isn’t about fancy ratios and percentages. In fact, I take an approach to home affordability in two ways. How does it impact my cash flow? And can I actually pay it off in a reasonable amount of time?
The word mortgage, has the French word “mort” in it. That means death. In my ideal situation, I never want to buy a house where I’m paying for it to my death. That’s not how I want to enjoy life.
So it makes sense to do some quick mental math when looking at homes. Given a salary, it can be assumed, as a rough estimate, that 25% of the gross income is gone to taxes (some may think higher).
As an example, if you are looking at a $1M dollar home in Toronto, and you are making $100,000 a year, that means total free cash flow for a year without buying anything is roughly $75,000. With a $1M home, that means the earliest I could pay it off without spending a dollar on anything else is 13 years. No food, no entertainment, no fun. 13 years of labour!
Now when you factor in the need to spend for necessities the earliest possible year to get to mortgage free might be closer to 20 years! 20 years! This is where some common sense comes in. A house may be affordable from a month to month basis, but it really locks you in into paying a mortgage for a very very long time.
What Can You Give Up
When it comes to buying a home, you have to ask yourself, “is that something I am willing to commit to?” “Is that the lifestyle I want to lock myself into?” Even if you can afford the monthly payments, would you be comfortable knowing that you will have very little cash flow to do anything else in your life?
That’s the lifestyle question you need to ask yourself when you buy a home. What can you give up? What do you have to give up? Knowing how expensive a house is and how much after-tax income you will have, are you willing to make those big sacrifices?
In today’s housing market, buying a home has become a big commitment. You have to be all in and be comfortable living with less luxuries in order to obtain a house. Can you live without a Gucci bag? Can you live with taking TTC rather than driving? Can you opt to eat in everyday rather than fine dining? Can you skip vacations? These are the types of sacrifices that have to be made in order to achieve home ownership.
Look deep within yourself in order to determine if giving up your current lifestyle with greater cash flow is worth it to become a home owner? That’s the real answer to affordability.