These days I rarely read a non-fiction book cover-to-cover, instead I flick through to grab key ‘big ideas’ to evolve my thinking. In the past year one book I delightfully read in full was “Predictably Irrational” by behavioural economist Dan Ariely.
As I immersed myself in the insights there was one in particular, right at the very end that I read as a personal challenge. (page 285, 2009 revised edition, pbk)
Dan Ariely described how when he and his wife Sumi went to buy a house he asked some experts he knew “including a few finance professors from MIT and investment bankers” what seemed to him like a simple question.
It is a question you have probably considered too.
“How much should I spend on a house?”
Ariely describes how everyone told him the same thing – a way to calculate how much he could borrow based on his income and the interest rate. But that’s not the question he asked.
Ariely noted “when I tried to push for an answer, the experts told me that they had no way to help me figure out the ideal amount we should spend and borrow.”
Can you see why I read it as a challenge?
Well, I have the answer for you Mr Ariely (I hope one day I can call you Dan).
First, let me share Ariely’s behavioural conclusion from his experience:
“When we can’t figure out the right answer to the question facing us, we often figure out the answer to a slightly different question, and apply this answer to the original problem.”
Hopefully you can see the potential issues in that human decision making.
How much you should spend on your next house
The maximum price you should pay for your next house is the sum of:
- Your saved deposit
- Transaction costs
- The maximum amount you should borrow
The maximum amount you should borrow is a function of:
- the loan term
- the average interest rate over the loan term
- your maximum affordable regular repayment amount.
For definitions of the categories described in the formula below see my ‘Pay Yourself First (in practice)’ model I described in my recent article on better budgeting.
Maximum affordable loan repayment equals your net after-tax income, less allocations for:
- Regular saving for your financial independence goal
- Regular saving for pre-retirement essentials
- Repayment commitments on other existing debts
- Irregular expenses
- Regular essential and comforts
- Impulses and indulgences (presuming you’ll still want the occasional splurge)
Now you have estimated the ideal amount you should spend on repayments rather than some alternate rule-of-thumb like 30% of your income.
To estimate your maximum affordable loan amount you then plug that repayment amount into the free borrowing calculators provided by the lenders. Or you can do it yourself in a spread sheet using the present value (PV) function.
You can download an example calculation here.
By the way, don’t use what the lender says you can afford to repay each period. Their calculation ignores your need to save for eventual retirement and often assumes you can live a lifestyle equivalent to the Henderson Poverty Index (in Australia).
In completing the affordability calculation I recommend you:
- Choose your loan term to match the amount of years until your financial independence goal. That way your debt will be repaid by ‘retirement’.
- Add an extra 1% to the lender’s current interest rate to give you a buffer.
When you actually apply for the loan you can apply for the typical home loan term of 30 years and just plan to make extra repayments in line with your calculation. This technique also builds your buffer for if misfortune strikes.
Life is a balance between doing something that brings us immediate fulfilment and doing something else that is an investment in future fulfilment.
Exercise, healthy eating and study are often investments in future fulfilment.
If the type of home you really want to buy costs more than the above estimate you then need to make an informed trade off.
Are you willing to cut other elements of your current lifestyle? Or are you willing to cut your expectations of future lifestyle like holidays, car upgrades and retirement?
Please share your thoughts
What do you think of my recommended approach to this common dilemma? Please share your reflections in the comments below as I’d really like to know. (You can share under a pseudonym to protect your privacy.)