So you’re pre-qualified for the million dollar home, but should you buy it?
According to Investopedia, “house poor” is a situation that describes a person who spends a large portion of his or her total income on homeownership, including mortgage payments, property taxes, maintenance and utilities.
If you’re house poor, you don’t have the money to do other important things such as saving, giving, or traveling. Basically, your home expenses eat up the majority of your disposable income.
Today, mortgage lenders are happy to lend money as long as your Debt to Income “DTI” ratio stays below about 40%. Your DTI ratio is equal to your total required debt payments (principal and interest only) divided by your gross (pre-tax) income.
Here’s an example:
- Total Debt Payments = $30,000
- Total Gross Income = $120,000
- DTI Ratio = ($30,000 / $120,000) = 25%
Problems With Using DTI
With DTI, the only considerations are income and debt payments. That should tell you something right there… it fails to consider any other home costs such as maintenance, insurance, taxes and improvements. DTI also leaves out savings, giving, taxes, travel, and other spending.
How Physicians Become House Poor
Let’s use the same example and assume this person is wanting to upgrade to a nicer home. Mortgage lenders, especially those offering physician mortgage loans, will likely approve a mortgage with annual principal and interest total payments up to $30,000.
- Total Debt Payments = $48,000
- Total Gross Income = $120,000
- DTI Ratio = ($48,000 / $120,000) = 40%
If you’re financing 100% and using a 30-year fixed mortgage at a 4% interest rate, that’ll get you into a mortgage just under $530,000. That’s a really nice home for an annual income of $120,000. It’s also the ultimate definition of house poor.
Now, let’s consider everything else that comes with owning a $530,000 home. The house alone with have the following annual expenses:
I’m sure you’re probably thinking that maintenance is too high, but it’s pretty realistic. Experts suggest setting aside 2 – 4% of the value of the home just to keep it in good working order. And this is before any upgrades!
Keep in mind we didn’t include any extras: home improvements, security systems, lawn care, landscaping, or HOA fees. This is bare bones – get you in the house and keep it in the condition you bought it. Nothing more.
So let’s see where the $120,000 annual income stands:
This leaves you a whopping $2,000 per year for giving, saving, and any spending above basic necessities! Zero wiggle room or margin for error. This screams house poor. And this is how lenders determine the maximum amount that they’ll loan. It’s basically the most you could possibly handle and still be able to put food on the table (and that’s it). If they were to lend more than this (which they did back in the early 2000’s) it’s almost a guaranteed bankruptcy or foreclosure.
The Not So Obvious House Poor Example
There are different levels of house poor. Let’s say a young physician is starting in practice and wants that million dollar home. Let’s see how these numbers shake out.
With a DTI of around 35%, you’ll qualify from the lender’s perspective with lots of room to spare. You’ll be left with ~10% of income to furnish the home and bump up your lifestyle a touch above the level you were living in residency. It’s unlikely there will be any leftover to save, though, so you’d better be prepared to work forever. Your kids won’t get any student aid for college because you make too much money. And you aren’t in a good position to have any leftover money to help them. So they better be prepared to take out large student loans. But… you’ll have a pretty sweet house.
So what about $350,000 income? Is that gonna do the job? If we assume taxes increase to 30% and everything else is the same, you’re left with $82,712 per year (DTI ~ 25%). That would probably be enough to save for a very average retirement, assuming you were still relatively young. And the rest would allow for a very modest lifestyle increase. It would be very challenging to save for college costs and build up emergency reserves. But it would be possible with discipline.
Essentially, if your home expenses create a situation where you’re not able to live your ideal lifestyle, it’s a form of being house poor.
The Wrong Way To Determine Home Price
Most people ask the question, how much house can I afford at my income? This is the approach the lending and real estate industry use. This “debt first” approach is the wrong approach.
Some people use rules of thumb to determine the appropriate amount to spend on a home. This only works if you fit into the exact profile or situation the rule is based on.
The Right Way To Determine Home Price
First, don’t take this lightly. It’s not exactly easy to un-do a home purchase. And by all means, don’t rush! Take a minute to logically think through your best course of action first BEFORE you start checking out houses.
Determine Your Budget
Your budget should be based upon your goals and financial circumstances. FIRST – figure out what taxes will be, what you’d like to give, and what you should be saving to hit short and long term goals! What’s leftover is what you have to work with. Odds are you already have some financial obligations such as a family to support, student loans or other debts to pay off.
Subtract out your existing lifestyle and debt obligations from what’s leftover. This leaves the disposable income you should consider when making the home decision. And don’t forget to consider anticipated lifestyle increases and margin for error! Those should be included in the disposable income figure.
Set a goal for how quickly you’d like to payoff your home. If you’re thinking 20 years, you should look at 20 year mortgages. Don’t fall for the mind trick of convincing yourself you’ll go with the 30 yr and overpay regularly. Really? Show me someone that’s actually done that.
Don’t forget to add in all the other home expenses besides the debt payment when looking at total home costs. Using the $250,000 income example, here is how this might shake out…
Income = $250,000
- Minus Taxes (20%) – $50,000
- Minus Giving (10%) – $25,000
- Minus Saving (20%) – $50,000
- Minus Necessities (~150% poverty) – $30,000
- Minus Existing Debt – $30,000
- Minus Desired Lifestyle Increase (outside home) – $20,000
- Remainder (for home budget) = $45,000
Let’s assume the goal is to pay off the mortgage in 15 years or less. Based on this goal and the remaining cash flow, the home mortgage absolute maximum should be $350,000 (assuming 100% is financed at 4% 15 yr fixed). This is how that would look:
- Principal and Interest – $31,068
- Other Home Costs (4%) – $14,000
- Total Home Costs – $45,068
If the size of the mortgage goes above $350,000, it’s going to start eating into your other financial goals. Something will have to give.
So once you have a very specific budget, then it’s time start talking to lenders and realtors and begin looking at homes within your price range. Don’t even bother looking at homes outside of your range. Make it clear to your lender and realtor that your range is set in stone.
Keeping Priorities In Order
The home purchase experience is extremely emotional. It’s hard enough to be logical and keep priorities in order when emotions run high. If those priorities aren’t set solidly in stone BEFORE starting the process, you’re setting yourself up to make a poor decision.
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