Figuring Out How Much House You Can Afford

Figuring Out How Much House You Can Afford

When you’re thinking about buying a home, how much you can afford is a critical question to answer. And it turns out there can be more than one answer to it. The number can change significantly depending on how you define afford. The question potential home buyers should focus on is: How much home can I comfortably afford?

You Can Uncomfortably Afford More

There are lending ratios that are used in the mortgage approval process, but those are really to see if you can afford to repay the loan, comfortably or uncomfortably. When it comes to mortgages, the numbers and formulas don’t factor in your being comfortable, just whether or not you’re at a high enough risk of actually defaulting on the loan. The ratios don’t care if you’re not able to save for retirement, take vacations, or even set money aside for future home maintenance.

The difference between what a lender determines you can afford and what you can actually afford can be quite large. Affordability is rarely a yes or no proposition. It’s a spectrum, and between comfortably affording and not affording something is uncomfortably affording it. It’s a place where you can make the payments, but they are a burden because you cannot afford other important things.

Know What You Can Comfortably Afford

So if lending ratios only solve for what you can uncomfortably afford, how do you figure out what you can comfortably afford? This is answered with a spending plan, one that’s not just based on typical monthly spending but also averages in everything else. By doing so you are accounting for  future home maintenance spending and other non typical expenses. Your spending plan can make sure vacations and other lifestyle expenses are covered by your income, in addition to what is allocated to housing.

Include All Housing Expenses

While a mortgage payment is a big part a homeowner’s expenses, so are property taxes, insurance, and maintenance. In some cases, taxes and insurance may be escrowed by the mortgage company and part of the monthly payment, but building up savings for home maintenance is left to the homeowner. Maintaining a home is expensive, and you can’t wait until you need to replace your roof to start saving for it. Maintenance costs can average out to between 1% and 3% of the value of a home on an annual basis. And don’t forget to count any homeowner association fees.

At 1%-3%, that means annual maintenance on a $300,000 home could average $3,000 to $9,000 per year, or $250 to $750 a month, that cannot be spent on other things. And after you’ve spending plan you can apply a couple of other guidelines to keep your finances in check. These are all guidelines, not rules. They are tests to keep you reasonably close to a mostly unpredictable future. Individual circumstances may justify to higher or lower amounts.

The 25% Guideline

Aim to keep your total housing expense to 25% or less than your available, after-tax income. Total housing expenses include mortgage, taxes, insurance, and maintenance. 25% may sound low when compared with lending ratios that are based on gross income and do not include maintenance costs, but it’s more reasonable in the context of all your other spending. If you want to keep spending obligations to 50% of your income like with a 20-50-30 budget, than housing is half of your obligated expenses at 25%. There still needs to be room for utilities and other monthly services, transportation, and other necessary expenditures.

The ⅓ Guideline

A second test, independent of income, looks at liquidity and whether you have enough cash to purchase a home without taking undue risks. You want to have enough cash on hand to equal at least ⅓ of the home’s purchase price. If you do, you should have enough for a 20% down payment, closing costs, moving expenses, and move-in incidentals. The remainder should be pretty close to a good size emergency fund for a new homeowner with a mortgage.

You can buy a home with much less available cash, and you can spend a greater portion of income each month to pay for it. But just because you can, doesn’t mean it would be wise to do it. Owning a home should be about comfort and security.

Do you have an action plan preparing you for home ownership? Do you know how much you can comfortably afford to spend on a home? Financial coaching may help you with your home purchase plans. 

Posted by Dylan in Home Ownership, Spending
5 Ways to Make Investing Super Easy

5 Ways to Make Investing Super Easy

Getting started is one of the more challenging things about investing. It’s not because it is complicated or tricky; rather, it seems more complicated and tricky than it really is. Thankfully, there are a few ways to invest that are easy to get going, and they are not necessarily for beginners. Experienced investors do it this way because it’s easy, low cost, and really works.

1. Your company’s retirement plan

If available, investing through your company’s retirement plan is a great place to start, especially if your employer matches contributions. Find out the maximum amount matched because getting the full match is the first investment to make. Choosing funds within the plan can seem intimidating at first, but these next approaches may work well in your retirement plan too.

2. Target date mutual funds

Target date mutual funds are all-in-one investments that become more conservative by owning less stock as they approach a target date. They are usually a fund-of-funds and have names like “Vanguard Target Retirement 2030 Fund1,” where the year in the name is the target date, and you can choose the one closest to when you might retire. Look for Target date funds that use index funds and have low expenses, below 0.25%.

3. Asset allocation mutual funds

Asset allocation funds can be all-in-one investments and are similar to target date funds, except they do not change over time. The allocation to stocks and bonds remains consistent, and you can choose an allocation strategy that you’re most comfortable with. This may feel more comfortable for younger investors wanting less stock market risk compared with target date funds.

The difference between target date and ad asset allocation funds may not be as significant as it first appears, even if the allocations to stocks and bonds is drastically different. Because most investors begin with small amounts of money and slowly see their balances increase over time, the asset allocation early on has much less impact on that balance than it will in later years. And in those later years, the allocations of both types of mutual funds will be more similar.

4. A 3-fund portfolio

If all-in-one solution isn’t for you, you can get a globally diversified, low-cost portfolio with as few as three mutual funds. By matching a broadly diversified US stock fund with an international and US bond fund, you can build a portfolio that matches any asset allocation you want.

This is what the Simple Investing Plan on this site is. It’s very close to Vanguard’s Lifestrategy Funds but without an international bond fund. The Vanguard Funds also allocate 30% of the stock to international while the Simple Investing Plan is only 25%. The difference is primarily to make the math easier for the Simple Investing Plan.

5. Robo advisors

Robo advisers are investment management services that will invest your money in an appropriate asset allocation for you. It’s similar to asset allocation mutual funds with a few differences. Most robo advisors use exchange traded funds, also known as ETFs, instead of mutual funds. You also don’t have to choose your asset allocation before signing up. As part of the robo service, you provide some information and answer a few questions so a computer can recommend an asset allocation for you.

In addition to the investment expenses, which are usually very low due to the use of ETFs, the robo advisor charges an asset management fee. Look for those fees to be .25% or less. After adding in the ETF expenses, you really don’t want to spend more than .5% on investing. Betterment2 and Wealthfront2 are examples of two popular and low-cost robo advisor companies.

Help to get you started

If you want to manage your own investments but want a little help here and there, you can hire a financial planner by the hour3 to help you settle on an asset allocation, choose investments in your 401K or 4o3b retirement plan, or deciding between mutual funds and robo advisors.

Image Credit: Ryan McGuire

1 I don’t work for Vanguard or get paid to mention them. I just like their funds because they’re among the lowest-cost options available.

2 I don’t work for Betterment or Wealthfront, or get paid to mention them. I have no direct experience with either company and am not making an implied recommendation.

3 I used to work for the Garrett Planning Network, and I don’t earn anything if you work with one of its members.

Posted by Dylan in Investing
What is Financial Coaching?

What is Financial Coaching?

Financial coaching is when a client and a coach work together to identify, understand, and improve your personal finances. It is an interdisciplinary field, drawing on both coaching and personal finance expertise. A financial coach will meet clients wherever they are in their lives, identify their financial goals, and collaboratively develop an action plan to achieve those goals. This also means identifying obstacles in the way well as resources available.

How much does financial coaching cost?

Coaches may charge a fee by the hour or per coaching session. Some will offer ongoing coaching in exchange for a monthly fee. Hourly, session, and monthly fees can range form less than a hundred to several hundred dollars.

Structured programs may be offered as packages of coaching sessions intended to be used at specified intervals, over a specific period of time. They may also be paired with course work or other activities as part of the coaching program. Prices for coaching programs can run from a few hundred to a few thousand dollars.

How often to clients and coaches meet?

How often a client meets with their financial coach is driven by each client’s needs. Some meet weekly at first, but once or twice a month seems common. As coaching progress, frequent meetings should become less necessary. Monthly may become quarterly and eventually just once or twice a year.

Cost can also affect the frequency of meetings. If a client can only afford to meet once a month without creating a financial burden, then once a month for a period of time might make sense. Many financial coaches are flexible and can plan out a meeting frequency with their clients that fits their budget.

Are financial coaches licensed?

There is no license to be a financial coach. Because financial coaching is not regulated, seek out a coach with legitimate certifications.  While licenses are issued by government, certifications are issued by organizations. A legitimate certification is issued by an organization that not only has rigorous requirement to become certified, but it also has the ability to enforce standards and take meaningful disciplinary action when appropriate.

Certifications can provide assurances to consumers. For example, coaches should not be selling financial products and or other services to their clients, but there is nothing to prevent a financial coach from doing it. However, if the coach is an Accredited Financial Counselor®, or AFC®, their Standards of Practice and Code of Ethics prohibit receiving fees from companies for recommending their products.

Image Credit: Nik MacMillan

Posted by Dylan in Coaching