Wednesday, May 27, 2009

how much can we afford?

When a person embarks on the tumultuous journey of a first time home purchase, or for that matter a second or third time home purchase, one of their top priorities is often 'how much can we afford?'. Better yet, I feel the question should be 'how much of our after tax and utility money should we allocate towards paying off our mortgage'.

If you choose to use online tools in order to give you this information, please avoid using this one: Canadian financial news source The Globe & Mail runs a great website called globeinvestor.com. On this website down the left panel in the 'resources' section you'll find a link called 'Mortgage Snapshot'. This link contains the latest mortgage rates from various lenders as well as a chart titled 'How Much Can You Afford'. The chart indicates that if you earn a gross income is $120,000 you can afford a mortgage of $461,808, which provides a home worth $615,744 using a 25% down payment of $153,936 and a 5.8% interest rate. What!

Let's look at this a little closer. Let's assume this gross income is made up of a dual income couple earning $60,000 each per year. After tax, Employment Insurance Contributions, and Canadian Pension Plan Fees they would bring home about $44,000 each, or $88,000 per year. Let's remove RRSP contributions of a responsible 10% of gross income ($12,000 total). Let's also remove a conservative property tax amount of $2,500 per year, heating of $1,500/year, and electricity/water of $1,500/year.

We now arrive at a value of $70,500 for the money our lovely couple will actually have access to, after the tax man, heat, power, and retirement are all taken care of. This is $2,712 bi-weekly.

Using the 'What Will My Payments Be' calculator on BMO.com we see that this couple's bi-weekly mortgage payment would be $1,333. Taking their mortgage payment as a percentage of the money they'll actually have access to, we arrive at 49%. If they decided to make accelerated bi-weekly payments instead to reduce their amortization time to under 25 years, the figure becomes $1,450 or 53% of their accessible funds. So more than half of their disposable income would go to mortgage payments, and this is not even accounting for other fixed costs like groceries and insurance. This situation would be far from ideal. In fact, it might not even be possible. Considering vehicles, daycare, clothes, gifts, cable tv, maternity leave, vacations, and a broken furnace, this mortgage does not seem feasible in the least.

The source for this information on the globeinvestor website is not listed. I believe that this chart is very poor resource for home buyers and it is irresponsible of The Globe & Mail to provide this resource to reader.

6 comments:

Nurseb911 said...

Great topic MG!

I think far too many people simply assume they can afford whatever the maximum the bank will give them, ~30% of gross income allocated to their mortgage payments. I took a different perspective with my first home purchase.

My income, the larger amongst my fiancee and me, HAS to cover all our monthly expenses (mortgage, utilities, insurance, car payment, misc, etc) and hers is 100% savings. Far too often I think couples try to "live within their means" on a dual income.

I got preapproved for significantly more mortgage than I needed, but that doesn't matter to me. If my future wife decides to stay at home with our first child I want to ensure that our monthly expenses are covered by my salary after taxes. If I go beyond that amount my view is that we're living beyond our means. Savings is the key to financial success because of what it allows you to do: pay off debt.

Astin said...

What's wrong with that number? It's 31% of gross income under accelerated bi-weekly, which is below the maximum a bank will allow you to put towards a mortgage.

I'm not saying it's sensible, but it's certainly the industry standard in Canada. On top of that, since you already took out taxes, utilities, and retirement planning from their numbers, you're still leaving them with roughly half their NET income to use for various and sundry items. $2600/month in free-and-clear money, or $31,200/year seems like plenty to cover broken furnaces, reasonable vacations, and family costs, unless it's a very wasteful and excessive couple. It's not like the furnace breaks down every month.

Traciatim said...

I agree, banks seem to want you to borrow far more than you can actually afford (pay for and afford are two entirely different concepts).

When I was shopping for a house just two years ago I had an income hovering right around 40K, and the bank had sent me a letter stating that about 145K would be the maximum I could afford. I ended up purchaseing a house for just over 100K instead. I'm incredibly glad that I did with the way things worked out in our family and the finances.

I think the old rule of thumb that the mortgage should be no more than 2-3 times income really works well. More people should know it, but it's not in the best interest of real estate agents, mortgage brokers, banks, or anyone else involved to teach it.

Anonymous said...

And then take that mortgage and recalculate it at 6-8% (or more) in 3-5 years. With interest rates so low right now, this causes the payments to jump considerably.
This, to me, is the scariest thing about all of these big mortgages being issued right now. Central bank interest rates won't stay at 0% forever!

MG (moneygardener) said...

Astin,

$2,600 per month after mortgage payments and some utilities for a couple who lives in a ~$500,000 house?

$400 car payment (just one car)
$600 day care (assume one kid under 5)
$225 car insurance (two cars)
$150 cable/phone/internet
$400 gasoline (two cars?)
$600 groceries
$50 home insurance
= $2,425

This leaves $175/month for:

Clothes
Gifts
Haircuts
Vacations
Home Repairs
Entertainment / Dining Out
Car Repairs
Appliances
Furniture
Diapers / hygeine products
RESP contributions
Gym Fees
Sports Fees
Etc. etc.

Doesn’t seem like plenty left to me. I don’t think this couple would have to be wasteful to go into negative territory each and every month.

Anonymous said...

Banks are always happy to supply the rope for you to hang yourself with if you so choose. (as we have seen-literally-down south.) I've always thought mortgage calculators should include questions about the number of kids you have, etc. (and whether or not you plan to enroll them in hockey!)