One of the most fulfilling parts of being a financial coach is journeying with and helping people achieve financial goals that are important to them. One of the biggest, if not the biggest, financial goal you and I will face in our lifetime is to save for and purchase our first house. As a financial coach I also recognise that a big part of my responsibility to my clients is to give them the right advice, even if they don’t necessarily like what they hear.
Having worked with hundreds of young couples and individuals over the years, I have no doubt that the urgency to get into a house is intensifying, and with that urgency has come a financial recklessness.
I know that many people (perhaps even you) do not want to hear that they should first save a 20% deposit and that they should have at least a $10,000 cash reserve before buying a house, but it doesn’t make it any less true.
I understand the fear of rising house prices, the pressures of well-meaning parents, and the desire to keep up with the Joneses, but I hope that you will believe me when I say that no house is worth the stress that comes from an oppressive mortgage or unexpected expenses you are financially unprepared for.
The purpose of this series, “Mortgage Advice for Young Couples”, is to provide you with a proven decision-making framework to help you know when you are financially ready to make the jump and purchase your first house.
In the first blog in this series, Mortgage Advice for Young Couples Part 1: How Much Do We Need to Save For a House?, I provided an overview of how much you need to save before buying a house and outlined all the costs you need to consider.
In this second blog, Mortgage Advice for Young Couples Part 2: How much can we afford to spend on a house?, I want to outline the process I use with all my clients to help them identify how much they can afford to spend on a house. This process is not rocket science but it is very objective.
But first, let’s look at the two most common errors people make when deciding on what they can afford to spend on a house:
Relying on what the bank or mortgage broker tells you they will lend you
Comparing your current rent with what you would be paying on a mortgage
Okay so let’s now look at how you should go about deciding how much you can afford to spend on a house.
Step # 1 – Get a comprehensive understanding of your expenses
I know it will come as no surprise to you but the first thing you must, must, must do is sit down and get a comprehensive understanding of your expenses. I know this can be a hassle but you are about to make the biggest spending decision of your life – take a couple of weeks to get your head around your finances.
The temptation when we want something (like a house) is to underestimate what we spend. Don’t! Avoid the temptation to understate your expenses and be as realistic as possible.
Step # 2 – Convert both your income and expenses to a monthly figure to make a direct comparison
Once you have identified all of your expenses, convert both your expenses and income to a monthly figure so you can make a direct comparison between what you earn and what you currently spend. In the Power of Budgeting Workbook, you will see a Position Summary page that will help you make this ‘apples to apples’ comparison. As a starting point, this will help you see how much savings capacity you have in your current situation.
Step # 3 – Add in the costs of house ownership
Having now gained a good understanding of your current expenses and cash flow, we now need to look at what your budget would look like when you add in the costs of owning a house as a monthly figure.
Start by taking out the rent you are currently paying (if you pay rent) and replace it with the monthly mortgage repayments you anticipate you will be paying.
Then you need to add in the costs of owning a house that you may not have previously had. These expenses are likely to include: council rates, water usage, building insurance, allocations for repairs and maintenance, allocations for new household items, garden equipment and furnishings. You also need to consider that if the house is bigger it may cost more to heat and cool. Again, it is really important to be realistic in how much you allocate to each expense.
What you have now is a realistic picture of what your everyday budget would look like as a home owner. The important number to look at here is – do you have a surplus of deficit once these additional figures were added in?
Step # 4 – Fine-tune to identify what you can afford
Having completed the above 3 steps, we now have a foundation upon which we can make wise and objective decisions.
The number one principle of wise money management is that you must not spend more than you earn. If you budget is now showing a deficit having added in the costs of owning a house, you know that you will need to either pull back your expenditure or you will need to decrease the size of the mortgage you are taking on. But again, it is essential that you are realistic as to which costs you cut back and by how much.
If, on the other hand, your budget is showing a surplus, you will be able to play with the possibility of a slightly larger mortgage. Bear in mind if a larger mortgage means a larger house, then other ownership costs are also likely to increase as well.
Step # 5 – Build in a buffer
By tinkering with the budget above you will get a really good feel for what you can afford and what you can’t, but it is important that you build some fat into the process as well. By this I mean don’t take the biggest loan you can afford; leave yourself some breathing space – in fact the more the better.
The first thing I encourage you to do is calculate mortgage repayments based on at least 7%. The Australian banks recently ran stress test scenarios on their loan books based on a 7% variable interest rate. The 50 year average on variable rates in Australia is actually 8.61% and the 20 year average is closer to 7.5%. While interest rates do look set to stay low for a while, don’t fool yourself into believing they will stay this low for ever. Factor at least a 7% interest rate into your calculations in step # 3.
The second thing I encourage you to do is take on loan size that leaves you the capacity to at least double the principle repayments on your loan over the first 10 years.
Most Australians love the little saying that “rent is dead money”. We like this saying because we believe it justifies the notion that we should buy a house no matter what the cost. Unfortunately they forget that interest is also dead money and that most Australians will end up paying more than double the initial price of their house in interest to the bank.
On a $350,000 house loan at 6.5% over 30 years you would pay $446,404 in interest at a total repayment of $796,404!! Make sure you build some fat into your budget when considering what you can afford. Regular additional repayments in the early years of your loan will have a significant impact on the loan term and the interest you ultimately end up paying to the banks.
Too often we make financial decisions without any means to quantify what the outcome is likely to be. Buying a house is too big a decision to leave to ‘sheer dumb luck’ (as Professor McGonagall would say). Hopefully by following the steps above you will find an easy process to objectively identify how much you can comfortably afford to spend when buying your first house.
In the third and final blog of this series, I will focus on what to look for when getting a home loan and what the ideal loan structure is.
As always should you have any questions regarding this blog please don’t hesitate to get in touch; we would love to hear from you.