What’s the Cheapest Way to Buy a New Car?
July 2, 2019What Type of Mortgage Should a Business Owner Have on a House?
July 11, 2019How Much Should a Business Owner Pay for a House?
Whenever I work with business owners, they often ask me, “Justin, how big of a house should I buy?” In other words, they’re asking me how much money they should pay for a house. To answer their question, I quote famed American author and business theorist, Dr. Thomas Stanley. In his book Stop Acting Rich, Stanley says, “Nothing has a greater impact on your wealth and your consumption than your choice of house and neighborhood.” He goes on to say, “If you live in a high-priced home in an exclusive community, you will spend more than you should, and your ability to save and build wealth will be compromised…” Ultimately, the answer to “How much should a business owner pay for a house?” boils down to the question, “What do you want to accomplish in life?”
Time Index:
- 00:47 – How Much Should a Business Owner Pay for a House?
- 01:10 – How Millionaires Think
- 03:13 – A House is Not an Asset
- 06:16 – Some Facts and Figures
- 07:51 – Be Wary of Taking on a Huge Mortgage
- 10:13 – Millionaires Don’t Live Lavishly
- 15:37 – Wrap Up
How Much Should You Pay for Your Home?
You know, one of the largest determining factors of your savings rate is your home. I know that you’re probably thinking, “Uh, Justin, that would be my income level.” To a point, that is correct. However, people with larger incomes tend to also buy larger houses. Likewise, 29% of homebuyers say that they feel less financially secure than they did before they purchased their home. With so many people that will be buying homes in the next few years, this becomes a very pertinent issue. So, how much should you pay for your home? Well, let’s first look at what you can afford.
RELATED CONTENT: Why Your Lifetime Savings Rate Matters.
Is Your House an Asset?
Most business owners have a desire to save money and build wealth. Why else would they invest in a business? They consider their business an asset, right? Likewise, most people think of the purchase of a house as an investment, and see their home as an asset. Although this is technically true, I don’t view your home as an asset. And, apparently, I’m in good company.
In his book, Rich Dad, Poor Dad, Robert Kiyosaki makes the assertion that a house is not an asset. Instead, he defines an asset as “something which produces an income.” Since you cannot tap into the cash value of your house unless you sell it or refinance it, Kiyosaki would say that it is not an asset.
Some would argue that Robert was wrong. In fact, back in 2004 through 2007, there was a substantial real estate run-up. I can remember contractors quitting jobs at Fortune 500 companies, borrowing $300,000 to $600,000, building a house, sitting on it for two years, and selling it for twice its original value.
Even in our current economic climate, there are many who still believe that business owners should buy as large of a house as possible. The thought behind this is that they can watch the house exponentially appreciate, thus multiplying their net worth. That’s when I lean on Robert Kiyosaki’s definition of a house. A house is not an asset. It’s not something you want to use to grow your wealth, unless we’re talking about rental properties.
Your Home’s Rate of Return
To further explain why your home isn’t a great vehicle for building your personal wealth, let me give you some data that I found. According to U.S. Census data collected from 1963 to 2008, the price of new homes increased by 5.4% annually. Similarly, the National Association of Realtors reported that the cost of existing homes increased by an average of 5.4% annually from 1968 to 2009. Pretty impressive. Furthermore, the Case-Shiller Index reported home values rising by 3.4% annually between 1987 and 2009.
At this point, I can hear you saying, “Man, Justin, that’s not too bad. That’s a 5% increase in my home’s value. If I can get a 5% increase, then I can go out, buy a huge house, and get a nice return.” Well, you might want to keep reading before making any rash decisions. Between 2000 and 2019, housing experienced an average return of 2.35%. See, whenever I gave you the 5.4% rates, those ended right before the market crashed. The housing market doesn’t guarantee you a 5% return on your investment.
So many people go out and buy the most prominent house they can afford, but it’s detrimental to their long-term success. Dr. Stanley explains it this way:
“If you live in a high-priced home in an exclusive community, you will spend more than you should, and your ability to save and build wealth will be compromised… [P]eople who live in million-dollar homes are not millionaires. They may be high-income producers but, by trying to emulate glittering rich millionaires, they are living a treadmill existence.”
Friends, I don’t want to live a treadmill existence. I want to build real wealth, and I want to build true wealth while I’m accomplishing my dreams and my goals. Let me explain.
What the Bank Says You Can Afford
Back in 2014, my wife Emily and I built our dream house. We purchased 28 acres on the Tennessee River with cash, but we went to the bank for financing on our house. We weren’t trying to build anything showy or flashy; we just wanted to build a home that met our needs. We were shocked when the bank approved us for a loan amount of $800,000. That amount of money for a house may not be a big deal to you if you live up north or out west, but here in East Tennessee, the average cost of a home is about $171,000. Therefore, $800,000 for a home loan is a lot of money. So, when the bank said $800,000, Emily and I laughed.
We decided to follow my advice, since I’m a practice-what-you-preach person. We kept our residence as small as was feasible for our family to achieve our dream of living on a farm. If you exclude the property we had already purchased, Emily and I spent right at $300,000 to build our house. It’s 2,400 square feet, and in reality, it wouldn’t have been that much except we wanted wrap-around porches, a metal roof, and barn wood flooring.
How Banks Determine What You Can Afford
There are two primary methods that mortgage lenders use to determine how much of a mortgage you can afford. The first is what is known as the front-end ratio or the housing ratio. This method looks at what percentage of your income would go toward housing expenses. Now, housing expenses go beyond your monthly mortgage payment. Instead, it refers to all of the expenses of homeownership, including your monthly mortgage payment, property taxes, homeowners insurance, and homeowners association fees, if applicable.
To calculate your front-end ratio, add up your monthly housing expenses and divide it by your gross monthly income, then multiply the result by 100. For example, if the sum of your housing-related expenses total $1,800 and your gross monthly income is $6,000, your debt to income (DTI) ratio is 30 percent.
The other method is what’s known as the back-end ratio or the debt to income ratio. This method shows how much of your income would be needed to cover all monthly debt obligations. The back-end ratio factors the mortgage and other housing expenses, plus credit cards, auto loans, child support, student loans, and other debts. However, living expenses, such as utilities and groceries, are not included.
When calculating your back-end ratio, add up all your monthly debt payments, including your housing expenses, and divide the result by your monthly gross income. Let’s assume your car payment is $500 per month, you pay $150 per month in student loans, and $200 toward credit card bills each month. This brings your total to $850. Combine that with your $1,800 in monthly housing expenses and you get $2,650 in total monthly debts. Based on your monthly income of $6,000, your back-end ratio would be 44 percent.
The Practical Math
Lenders typically look for a front-end ratio of around 28 percent. Likewise, they generally like to keep the back-end ratio somewhere around 36 percent. They’re hesitant to put the buyer in a position where they are paying much more than this because it often leads to default and that’s not good for any of the parties involved. Foreclosures are damaging to the home buyer’s credit and they cost the mortgage company quite a bit of money.
In order to make an informed purchase and ensure that it’s one that you can afford, it’s a good idea to calculate your front-end and back-end ratios before you begin searching for your dream home. So, how do you find these figures? It’s an easy equation. Simply multiply your monthly income by the target percentage. For example, if your monthly income is $6,000, then your front-end ratio equation would look like this: $6,000 x 0.28 = $1,680.
The same formula applies to your back-end ratio. The only difference is that you will need to calculate your total monthly debt payments and compare them to your results. Sticking with our $6,000 monthly income, your maximum for all monthly debt payments, at 36%, should come out to $2,160. As I said before, you find this with the same formula: $6,000 x 0.36 = $2,160.
However, there are other influential factors that lenders will look to. Depending on the amount of down payment and your credit score, it’s possible that you could receive a mortgage that puts you a little above or below your front and back-end ratios.
How Much Should You Afford?
Now we know what you can afford. But what should business owners pay for a house? You see, once we begin to get a little success under our belts, the spender tends to come out in us. As business owners, we’ve scrimped and saved and sacrificed to make sure that our business is successful. We know what it means to survive on rice, beans, ramen noodles, and even mashed potatoes and gravy. Having gone through all of that, it’s perfectly normal for us to want to reward ourselves once we reach a certain level of success.
However, the entire crux of this post is to ask the question and to provide the answer. So, how much house should you afford? One that’s as small as possible to achieve your goals and dreams. But why does it matter what business owners pay for their homes?
As I stated at the beginning of this post, the home you choose is the biggest determining factor to your success. The size of your home and the materials that were used in its construction can have a major impact on the cost of your insurance coverages. The materials will likely have a significant bearing on your maintenance and repair costs. Likewise, they can determine how much your monthly utility rates are.
Along with all of this, the location of your home will decide your taxes. You will have to pay property taxes wherever you live, but you might be able to avoid state-level income taxes. Additionally, your home could affect the wear and tear on your vehicles, depending on how much of a commute you have. Folks, there are so many costs that stem from your home. The more you pay to keep up your current lifestyle, the less you have to save or invest in your future. So, ask yourself, what should business owners pay for a house? And don’t forget to consider how the total cost will affect your financial success.
Live Within Your Means to Accomplish Your True Goals
Emily and I could have “afforded” $59,520 per year in housing payments ($4,960 x 12 months), and we could have put $200,000 cash down on a million-dollar house, but that’s all we could have done. Most of our monthly budget would have gone into our house payments. We wouldn’t have the extra money in our budget each month to save or invest, nor would we have had the extra money in our budget to go on vacations or take care of life’s emergencies when they arise. All of our cash and monthly budget would have gone into one asset – our house – and that particular “asset” only earns roughly 2.3% – 5.4% annually (as we determined above).
Instead, we chose to live within our means. We didn’t want to invest all of our cash and monthly savings into our home. Our house will appreciate at 2-5% annually no matter how big it is or how much money we owe on it. Retirement accounts, investment accounts, and other assets typically earn higher returns than that annually, and we can tap into the power of compounding interest. Therefore, we wanted to diversify our investments and max out our yearly retirement account contributions. Additionally, we wanted to build up our emergency funds and have enough money left to take vacations and make memories.
For help building your ideal monthly budget, visit How Much Should I Pay Myself From My Business?
Wrapping Up…
So what am I trying to say? How much should a business owner pay for a home? Well, you can buy the biggest house the bank says you can afford. You can. However, if you tap out your monthly budget on house payments, you will not be able to build wealth in other places. Nor, will you have enough cash on hand to take care of life’s emergencies as they arise. Mostly, your house will be your biggest and only asset, and as Robert Kiyosaki explains, it’s not making you any money. To retire to the life of your dreams, you’ll have to sell the house to capitalize on your investment. But do you want to do that?
You don’t have to buy the biggest house you can afford. Sure, you want to be comfortable in the house, but you don’t want to sink all of your wealth into one asset. If you buy a house worth much less than the bank says you can afford, you can invest your cash and monthly savings into other assets. You can invest in your business’s growth, the stock market, retirement accounts, save for vacations of a lifetime, your children’s educations, and much more! You can have a beautiful home and still reach your financial goals and dreams.
If your goal is to live in the biggest and best house, then do it! However, if your financial goals are more comprehensive than that, buy small, and save big.
Stay with us in this Personal Finance for the Business Owner Series as we talk about what type of mortgage you should get for your house!