How Much House Can We Afford? - Finding Funds for the Down Payment

Sep. 10

KEY POINTS

Homeownership Challenges: Prospective homebuyers often face difficulties saving for a down payment, especially when housing costs outpace their annual income, leading to a precarious financial situation in a competitive real estate market.
Determining Affordability: Figuring out how much house you can afford involves considering various financial ratios, income, amortization period, credit score, down payment, property taxes, insurance, and the type of mortgage, all of which play a role in determining your borrowing capacity and monthly expenses.
Financial Modeling: Our models analyze the adjustments required for a couple with a $100,000 income to save for down payments on both a $600,000 house and a $1,100,000 home. However, securing the down payment is just the beginning; effectively handling the expenses associated with homeownership demands thorough budgeting, streamlining, and meticulous financial planning to cope with the considerable mortgage commitments and their consequences.

The Down Payment Dilemma: A Common Challenge

It is a challenge to decide if you should buy or rent your home. This article is for you if you have decided that home ownership is for you.

In today's competitive real estate landscape, prospective homeowners often grapple with the challenge of saving for a down payment, especially when housing costs seem to outpace their annual income. When combined with the effects of overall inflation and escalating interest rates, this situation can create a precarious financial predicament.

This article is here to guide you on the path to homeownership. We'll uncover valuable strategies, financial insights, and innovative approaches to help you accumulate a substantial down payment, bringing your dream of owning a home within reach.

Join us as we explore practical steps towards that cherished goal, opening the door to your very own home.

How Much House Can We Afford? – Financial Ratios

This is a simple question that can elicit a complex answer.

There are several rules of thumb that can estimate the maximum mortgage you should consider taking on. For example, a common guide is to limit your housing related costs (e.g., principal, interest, property taxes, utilities) to 28% of gross monthly income.

Financial institutions have their own financial models. Two common models are the Gross Debt Service Ratio (“GDSR”) and the Total Debt Service Ratio (“TDSR”).

The GDSR calculates the percentage of your gross household income required to cover your housing costs including principal, interest, property taxes, and utilities.

The TDSR calculates the percentage of your gross household income required to cover your mortgage costs, plus all other debts and loans (e.g., student loans, lines of credit, auto loans, credit card payments, child support).

How Much House Can We Afford? – Contributing Factors

The ratios above involve factors unique to everyone.

Income

The combined earnings of you and your partner play a pivotal role in establishing your borrowing capacity. Your tenure with your present employers and work history will be considered in the calculations made by your financial institution.

Moreover, your employment type, such as full-time, part-time, or seasonal, can also influence your borrowing eligibility.

Amortization Period

The length of your amortization period (e.g., 15, 20, 30 years) will impact on your monthly payments. The longer the term, the lower the monthly payments. However, a longer term translates to an increase in overall interest costs.

In a rising mortgage rate environment, borrowers must ask themselves Should we extend our mortgage amortization? and lower the monthly payment. The answer to that question often surprises borrowers.

Credit Score

A higher credit score generally results in better mortgage rates and terms. A lower score can limit your borrowing capacity and increase the cost of borrowing.

Maintaining a high credit score can save hundreds of thousands of dollars depending on the borrowing threshold and interest rate differentials.

We suggest obtaining a copy of your credit report at least a year before you intend to apply for a mortgage and creating a systematic strategy to steadily improve your credit score.

Down Payment

The amount of your initial down payment will directly impact the size of your mortgage, monthly payments, and interest costs.

Property Taxes

Property taxes represent a form of wealth taxation determined by multiplying the property's value, as assessed by the respective municipality, by the applicable tax rate.

As the property's value rises, so do your property taxes. These tax rates are set by local municipalities and can vary significantly from one municipality to another, potentially influencing your decision regarding where to live.

Insurance

The cost of home insurance can fluctuate significantly based on your location and the insurance company you choose. Consulting with an insurance broker or insurance agent can offer valuable advice and lead to substantial cost savings.

Type of Mortgage

Your monthly payments will be impacted by the type of mortgage you choose (e.g., fixed rate, variable rate).

Debt Obligations

The amount you can borrow for a home is influenced by your current debts. It's important to prioritize paying down high-interest debt. If you can secure favorable lending terms, including a lower interest rate, you might also want to explore the option of a consolidation loan.

Lender Specific Requirements

Lenders may employ the ratios mentioned above, but they each have their own distinct lending criteria. When seeking favorable lending terms from a reputable financial institution, a mortgage broker can offer valuable guidance.

House Much House Can We Afford? - $100,000 Income

$600,000 Home value

$120,000 Down payment (20%)

$480,000 Mortgage (80%)

A couple’s combined income of $100,000 would be considered average in many cities. We have considered the ratios above to derive the above variables.

Your specific financial circumstances may dictate a higher or lower maximum price.

Our model incorporates a 20% down payment.

Many borrowers secure mortgages with a down payment of less than 10%. However, a down payment of 20% or more can lower your borrowing costs and eliminate the need for additional mortgage insurance.

We made the following key assumptions:

Annual Rates

4% Housing appreciation

5% Income (salary, wages)

3% Inflation

6% Investments

The pandemic has reminded us how quickly housing prices and inflation can fluctuate by double digit rates. Portfolio returns are also subject to such extreme volatility.

Regarding income, individuals may require ongoing training, collective bargaining, potential job changes, or supplemental income sources (e.g., gig economy) to achieve the 5% target.

Risk Disclosure

It's important to note that while these assumptions are made in good faith, there is a potential for substantial deviation from actual results. The utilization of 5-year and 10-year timeframes in our models, due to their relatively short duration, heightens the risk of not tracking real-world outcomes.

Down Payment Budgeting Guidelines

We've developed two models focused on saving for a house down payment, one with a 10-year savings timeframe and the other with a 5-year savings horizon.

The model assumes two individuals earning $50,000 each, living in an apartment just outside a major city (e.g., New York, Toronto, London) to which they commute for work. They also own two cars, a pet, and have modest vacation plans.

Warning

The model assumes no additional savings for emergencies, education, wedding, or retirement. We do not recommend forgoing funding such savings initiatives. The model is designed to illustrate how income and spending changes can impact financial goals over defined periods of time.

The following tables summarize the initial year budget for each scenario:

Base (initial budget) with no savings
10-year savings plan
5-year savings plan

Let’s look at the dollars and cents of each option:

	Base	10 Year	5 Year
	$	$	$
Income	100,000	100,000	100,000

Expenses
Taxes & Gov’t Accommodations Bank fees Communications Food Transportation Vacation Gifts Donations Hobbies Entertainment Clothing Haircare Pet Medical	18,500 28,200 150 3,300 6,500 25,760 2,000 3,500 600 500 6,000 2,400 600 1,270 720 100,000	18,500 28,200 150 3,300 6,500 24,560 2,000 1,500 - - 4,440 2,400 600 - 720 92,870	18,500 24,000 150 2,640 6,500 14,880 2,000 800 - - 4,440 2,400 600 - 720 77,630
Cash flow – yr. 1	0	7,130	22,370

Now, let’s look at the expense allocations as percentage of income:

	Base	10 Year	5 Year
	%	%	%
Income	100.0	100.0	100.0

Expenses
Taxes & Gov’t Accommodations Bank fees Communications Food Transportation Vacation Gifts Donations Hobbies Entertainment Clothing Haircare Pet Medical	18.5 28.2 0.2 3.3 6.5 25.8 2.0 3.5 0.6 0.5 6.0 2.4 0.6 1.3 0.7 100.0	18.5 28.2 0.2 3.3 6.5 24.6 2.0 1.5 - - 4.4 2.4 0.6 - 0.7 92.9	18.5 24.0 0.2 2.6 6.5 14.9 2.0 0.8 - - 4.4 2.4 0.6 - 0.7 77.6
Cash flow – yr. 1	0.0	7.1	22.4

Highlights – 10 Year Savings Plan

The down payment can be saved in 10 years.

The annual savings rate increased by 7% in year 1 and rose to nearly 19% by year 10.

The following spending cuts as a percentage of income earned were made in year 1:

1.2% Car
2.0% Gifts (birthday, anniversary, holiday)
0.6% Donations
0.5% Hobbies
1.6% Entertainment
1.3% Pet care

Income rose at a 5% annual compounded rate and income taxes were adjusted accordingly.

While individuals may choose a different mix of spending cuts, the model illustrates the savings goal can be obtained by making modest lifestyle changes.

Highlights – 5 Year Savings Plan

The down payment can be saved in 5 years.

The annual savings rate increased by 22% in year 1 and rose to nearly 31% by year 5.

The following spending cuts as a percentage of income earned were made in year 1:

4.2% Accommodations
0.7% Communications
10.9% Car
2.7% Gifts (birthday, anniversary, holiday)
0.6% Donations
0.5% Hobbies
1.6% Entertainment
1.3% Pet care

Income rose at a 5% annual compounded rate and income taxes were adjusted accordingly.

Additional sacrifices need to be made in nearly every category to achieve the savings goal in 5 years instead of 10 years.

Accommodation was downgraded, which may be facilitated by changes to a combination of location, size, quality, and sharing accommodation with others. Cell phone and internet plans were downgraded. The 2 newer cars in the Base Budget have been replaced with a single used car. Gifts also took another hit to reach the target budget.

What About Houses > $600,000

The above analysis shows that, given the assumptions made, a couple earning $100,000 combined average income can save for the 20% down payment on a $600,00 home over a 5-to-10-year period.

Sacrifices will need to be made including saving for other milestone goals (e.g., emergency fund, education, wedding, retirement), current rental accommodation, number and / or quality of automobiles, charitable endeavors, hobbies, entertainment, and more.

As exciting as this may be, it may be a moot point for many families living outside a major city and commuting to work. Afterall, the average price of homes in such cities often exceed $1,100,000: not the $600,000 range modeled above based on standard industry lending guidelines.

So, let’s look at the feasibility of affording a $1,100,000 home on a combined income of $100,000.

How Much House Can We Afford - $1,100,000 Home

Down Payment – 10 years

A down payment in year 10 of approximately $326,000 can be achieved by downsizing from 2 cars to 1, driving a slightly less valuable car, eliminating donation and hobbies, trimming entertainment, and not having a pet.

Down Payment – 5 Years

A down payment in year 5 of approximately $268,000 can be achieved by making extreme spending cuts. This will likely include a substantial decrease in rental accommodation ($2,200 to $1,325 monthly cost in our model). Additionally, we had to relinquish ownership of both cars and replace them with on-demand ride services and transit. We eliminated vacations, donations, hobbies, pets, and drastically reduced the entertainment budget.

Ability to Cover the Mortgage

Saving for the down payment is just the first step; you must also find a way to manage the expenses associated with a $1,100,000 home with a combined annual income of $100,000.

The mortgages for the 5-year and 10-year plans are substantial at $1,070,000 and $1,300,000, respectively, even when considering an expected 5% compounded annual income increase. Even with an excellent credit score, securing a mortgage under these circumstances can be extremely challenging through a financial institution.

It's crucial to emphasize that committing to such a significant financial investment in a home can have a notable impact on other important life goals, such as education, weddings, and retirement. Keep in mind that mortgage payments are just one aspect; you must also factor in property taxes, upkeep, and insurance costs.

FINAL THOUGHTS

Achieving homeownership with an average income is feasible if you create a carefully crafted budget and adhere to it. Factors in the housing market that you cannot influence, such as increasing property prices, inflation, and interest rates, might affect when you can make your desired purchase.

We highly recommend creating a comprehensive budget and, if necessary, consulting with a mortgage broker or another financial advisor to ensure that your decision does not obstruct your progress toward achieving other significant financial milestones.

Featured