Back Nine Finance

Yesterday, we talked about Doing the Big Things Right (if you haven’t read it, go read it, then come back and continue). For most people, nothing in life will be a larger expense than buying a home. Inevitably, when people begin to start shopping for a house, the question always comes up:

How much house can I afford?

There are all kinds of calculators all over the internet that will allow prospective homeowners to plug in income and available cash (downpayment) information, and the model will spit out some number of how much house they can theoretically afford. However, most of these calculators fail to take into account a person’s full financial picture. They sometimes forget to remember that people like to do things other than just own an expensive house – like perhaps eating.

Most of these calculators were developed by banks  and mortgage brokers – the very entities that stand to benefit the most from people taking on as much debt as possible (full disclosure: I am a banker, but deal exclusively with businesses. I hate messing with mortgage loans – way too many rules.). Not to say that banks are inherently evil for developing calculators that provide such data, it’s just that that output is so generalized – and aggressive at the same time.

The Old School Rules

Back in the day, before the housing bubble changed all the rules, there used to be some fairly hard and fast rules for determining how much house a person or couple could qualify for (and by qualifying for this amount, that was supposed to mean it was “affordable”). The old school rules were primarily focused on 2 ratios:

Housing debt ratio: The housing debt ratio is the ratio of total monthly housing expense (loan payment, taxes and insurance) divided by gross monthly income. The target was generally accepted to be 28% or lower. So for example, if a person earns $5,000 per month, an acceptable (and by default affordable) amount for monthly housing expenses would be $1,400. $1,400 divided by $5,000 equals exactly 28%.

Back end debt ratio: The back end debt ratio is the ratio of total monthly debt obligations (including the housing expenses used above) plus other debt obligations such as car payments, student loans, etc., divided by gross monthly income. The target was generally accepted to be 36% or lower. Continuing the example above, if a person earning $5,000 gross per month has housing expenses of $1,400 per month, a $150 student loan payment and a $250 per month car payment, their total debt obligations are $1,800 per month. Dividing this amount by their gross monthly income ($5,000) yields a back end ratio of exactly 36%.

Here’s what I don’t like about the old school rules – they are all based on gross income. I don’t know about you, but I know what my gross monthly salary is, and I know I don’t bring home anywhere near that much each month. Every person’s situation is so different with regard to taxes, health insurance, 401(k) contributions and other things that ratios that fail to take into account these items seem doomed to be way off in most situations.

The New School Rules (or – A Plan for Epic Failure)

It won’t take long to explain how the rules changed from the Old School Rules during the recent housing boom an bust. They were stretched way past the limit, and in many cases, completely thrown out the window. Housing debt ratio of 50% – sure, no problem! Back end debt ratio of 60% – yes, please! Banks and mortgage companies were willing to bend the rules, and would be homeowners were more than happy to play along.

Talk about one big mortgage quagmire. It doesn’t take much intelligence to understand why spending 50% of your GROSS monthly income on housing expenses is a recipe for disaster, especially when you only bring home about 75% to 80% of your gross monthly income.

My Ratios for House Buying (Warning – These are a Bit Extreme)

If you read the article yesterday about Doing the Big Things Right (if you still haven’t read it, it’s probably hopeless, so I’ll shut up now), you’ll know that I am a HUGE believer in making smart and conservative spending decisions when it comes to big ticket items like houses and cars. That’s why I propose the following ratios, or rules of thumb when purchasing a house:

Back Nine Finance Housing Debt Ratio (Gross Method) – If you must have a number that you can calculate based upon your gross monthly income, let’s use this one. Stick to 15% or less. That’s right, I believe that your mortgage payment along with taxes and insurance on a monthly basis should be 15% or less of your gross monthly household income. Not 28%, not 50%, but 15%.

Back Nine Finance Housing Debt Ratio (Net Method) – I much prefer to make these type of calculations based upon net monthly household income (take home pay). I believe you should keep your housing expenses to 20% or less of your net monthly household income.

Too Extreme?

I realize that keeping housing expenses to 15% of gross income or 20% of net income might seem a bit extreme to some (or most). But, if you’ve been reading this blog for long, you know that my goal is not merely to be average. I’d like to have a life filled with wonderful things, interesting investments, fun adventures, etc. All of these things take money. With housing being my family’s largest monthly expense, the lower we can keep it, the more money we’ll have to use for other purposes such as investing or doing fun things.

I realize that few people will have the desire to play by these rules. I understand that housing is very expensive in many places around the U.S. (and around the world). Becoming wealthy is not a goal that everyone shares, but keep this in mind – if you desire to become wealthy, you have to play by a different set of rules than everyone else. All I’m trying to do is generate a set of rules that people on the path to creating wealth (including myself) can follow.

Questions for the day:

Do you believe the 15% gross/20% net housing expense ratios are too restrictive?

What percentage of your gross/net household income do your housing expenses (mortgage payment, taxes, insurance) represent?

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