As I continue on my epic journey of saving $40,000 for the house I eventually plan to buy in Halifax, Nova Scotia, I often worry if I’m being realistic about the price point I set and whether or not I’ll be able to comfortably afford my mortgage.
The “what can you afford” calculators offered by the big banks aren’t helpful because they vastly over-inflate the purchase price based on their outdated debt service ratios. (For example, Tangerine tells me I can afford a home worth $489,000. Umm no.)
At the same time, there are a bunch of age-old rules of thumb that are bandied about on the internet such as “don’t buy a home worth more than three times your income,” and but many argue that those are out of date in the hottest Canadian housing markets.
Fortunately, the Halifax housing market is not hot. In fact, it’s a buyer’s market. The average home price in this city slipped 1.2% to $304,441 this quarter. Good news for me.
Even though prices here are reasonable I’m still concerned about overextending myself with a mortgage and becoming house poor. So I’m going to run through all of the different rules of thumb for home ownership to see if I am indeed ready for the financial burden of home ownership.
Let’s use the following parameters for each rule of thumb:
Purchase price: $280,000
Down payment: 12.5% – $35,000
Mortgage: Five-year fixed at 2.49%
Carrying Costs: $1,850 (mortgage, insurance, utilities, internet, property tax)
First rule of thumb:
First, should I even buy a home in today’s real estate market? That’s where the price-to-rent ratio comes into play. This ratio compares the total costs of home ownership to the total cost of renting a similar property. Here’s how to calculate it:
Price-to-rent ratio = Average list price / (Average Rent x 12)
The thresholds on whether to buy or rent are as follows:
- Price-to-rent ratio of 1 to 15 = much better to buy than rent
- Price-to-rent ratio of 16 to 20 = typically better the rent than buy
- Price-to-rent ratio of 21 or more = much better to rent than buy
So we know our list price will be $280,000. After doing some research it seems I could rent a similar property for about $1,800 all included. So the math goes:
Price-to-rent ratio: 280,000 / (1,800 x 12)
Price-to-rent ratio: 280,000 / (21,600)
Price-to-rent ratio: 12.9
The rules above say it’s better to buy than to rent.
Don’t Buy a House More Than 3x Your Gross Income
This is one I’ve heard many times, but recently some people have argued that it should be abandoned. Personally, I think that signals a problem with our housing market, not the rule itself.
Here’s how it applies to us: my husband and I have a combined income in the range of $100,000 per year, so buying a home for $280,000 satisfies this rule.
Housing Shouldn’t Be More Than 35% of Your Net Income
This is a metric I subscribe to pretty strictly, and I used it to find the apartment I live in now. The carrying costs of the parameters above are $1,850, which is slightly less than 35% of our net income before my freelance income, once that is factored in, it is even less.
Your Fixed Costs Should Not Exceed 50% Of Your Net Income
I forget where I heard this one, I think from a realtor at an open house. She meant all fixed expenses, not just expenses related to home ownership.
If we bought a home for $280,000, our fixed costs would be:
- $1,850 for the home
- $91 for car insurance
- $135 for cell phone
That’s all of our fixed expenses. We have no kids (no daycare), no debt payments and we own our car outright. Everything else is variable.
Total: $2,076 which is 40% of our net income before my freelance income.
The Real Life Ratio
Developed and popularized by Rob Carrick, the Real Life Ratio is a spreadsheet that allows you to theorize not just if you can afford a home, but if you can afford everything else that goes along with, you know, living your life.
The real life ratio adds up your housing, daycare, debt, retirement savings and other fixed expenses and divides that amount by your monthly income. If your ratio comes out to less than 75%, you are good to go. I used our net monthly income excluding my freelance income, and my ratio came to 51%.
I really like this spreadsheet because it’s easy to add in extra amounts for daycare (even though I don’t have this expense yet) and it doesn’t let you forget about home maintenance (1% of a home’s value per year).
In fact, even if our incomes did not increase at all, and I added in $500 for daycare, bumped up my retirement contributions and started saving in an RESP, my ratio only went up to 64%, still well below the 75% threshold.
The Rule of 90
Have you read Garth Turner’s blog The Greater Fool? I go there sometimes when I’m feeling spendy and I need someone to yell at me about how overpriced the housing market is. He makes you feel good about stuffing your money in your portfolio instead of in real estate. Kinda like having a personal trainer yell at you. Same result. Don’t read the comments though. Just don’t.
Anywho, his rule of 90 states that the net worth you have tied up in real estate should less than 90 – your age. For me, the magic number would be 90 – 27 (assuming I buy next year) = 63%.
If I bought a home for $280,000 with $35,000 down I would have $29,120 in equity (the mortgaged amount includes $5,880 in CMHC insurance). I’d also have $10,000 in my emergency fund and $22,000 saved for retirement (ish) plus another $3,000 in short-term savings for a total net worth of:
$29,120 + $10,000 + $22,000 + $3,000 = $64,120
* I don’t include my car in my net worth as it is 10 years old and not worth much.
Of that $64,120, 45% of my net worth would be in real estate.
Based on most of these indicators, I’d be safe putting $35,000 down on a $280,000 home. Now I just need to get to my goal of $40,000 saved. Only $16,000 to go! Oph that still seems so far.
How does your housing situation stack up to these rules of thumb? Do you pass or fail? Have you heard of any other rules of thumb that I’m leaving out? I want to know!
Like what you’ve read? Check out some of my other posts:
- All posts on home buying
- How I paid off $38,000 in 24 months
- How I gave myself a $1,344 raise
- Your guide to Canada student loan forgiveness
- Download my free debt repayment spreadsheet
Photo Credit: Bernadette Gatsby