Here’s a look at the US home and family sizes starting in the 60s all the way to 2015. Note that the graphic below is based on the Census Bureau’s data.
This is very interesting. Back in the 60s, the average American family lived in a small house with ~1,200 square feet. The average family size then was 4. Today, the average American family lives in a big house with ~ 2,950 square feet. The average family size now is 2.5 (let’s just say 2). For detailed analytics, check this link.
Our current homes are 250% bigger than the homes in the 60s and the current family size is a little more than half than what it used to be. Meanwhile, the US median family income has only grown ~ 4.% annually, roughly offsetting inflation over the last 5 decades (in other words, it’s relatively flat).
The conclusion here is we are living in big and luxurious homes without the income to support this lifestyle. Where did we get the money to buy these big homes? Borrowed money. I won’t say I don’t like the homes now as they are so much nicer and more efficient than the ones in the 60s. But, I think we have gone too far that we have missed the mark of what truly makes a house a home. We have traded the life of pragmatism and common sense for a life of luxury, convenience, and borrowed money.
Clearly, this can’t go on forever. The first pause to this was in 2008 and 2009 during the subprime and credit crisis. Many people lost their jobs, homes, and many really suffered. Many would argue that the financial industry (bankers, rating agencies) is to blame, but you also have to acknowledge that home buyers were borrowing so much money beyond what they could afford to pay. Everyone had a role in the melt down.
I hope we have all learned our lessons. I hope…
How much loan can one afford?
What is the optimal loan amount can one take? As you can see, I didn’t ask the question: “How big of a home can one purchase?” Why? Because the purchase of a home is dependent upon one’s income.
Clearly, if you have a big family you would have to consider the size of your home, but at the end of the day, your real constraint is your budget or income. Let me share two approaches I use to determine the optimal debt one could take.
Multiple Approach.
One that is popular among lenders is the “no more than 3x income” approach (Given the “artificially” low interest rates, however, this number could be pushed to 4x to 5x. But, I believe if you go more than 3x, you are getting yourself into trouble). You also need to factor in how much down payment you are putting in. If you are putting in less than 20%, then you would need to pay PMI (Principal Mortgage Insurance) which is around 1% of the outstanding loan value (this stops when the equity equals 20%). Then, you have to factor in the cost of dwelling insurance, taxes, HOA, and other fees.
As an example, let’s say your income (wage) is $100,000. Then, 3 x $100,000 is $300,000. This means that your monthly principal and interest for the next 360 months (or 30 years), assuming a 3.80% interest rate, is $1,400/month. Add taxes, insurance, HOA, etc. Let’s just say this is about $600 per month; then, you end up paying ~$2,000 per month.
With an annual salary of $100,000 and assuming an effective tax rate of 20%, you end up having a monthly after-tax take home pay of $6,666 per month ($80,000 annually). Now, divide $2,000 by $6,666, that is ~30% of your take home pay. Another way to look at this is ~1/3 of your pay goes to home (and related) payments. I like this approach. It is simple and straightforward. But, it has a drawback which is addressed by the Cost Approach.
Cost Approach
I personally like to use is the Cost Approach because it goes into the details. Let’s start again with the income of $100,000. We know that after taxes, this is about $80,000 or $6,666 per month. The next step is to factor in the family’s monthly expenses. A typical one would look something like this (depending on where you live, you may need to adjust the values to account for the difference on cost of living):
As observed here, you can afford the $300,000 house and still save anywhere from 6% to 31%. Now, let’s say you want to save 15%, then you either have to cut back on the other categories – eating out less, cutting back on expensive cable connections, and others. Using the cost approach allows you to run scenarios and analyze your income position and spending profile. It helps you make smart decisions on your finances, and banks won’t have a way to sell you out.
Personally, I use both methods. I use the first method for a back-of-the-envelope calculation. It is quick, and I can immediately gauge how much I could spend on housing and still save money. I use the cost approach to get into the details and see if my back-of-the-envelope calculation does make sense.
Some may wonder what to do if they make a lot more than $100,000 in salary if they can get a bigger home. The answer, of course, is YES. But the real question is what if something happens to you? Let’s say there is another recession. Nowadays, it is so easy for companies to lay people off.
Those days of lifetime employment are gone. Also, just because you can afford some things doesn’t mean you have to buy them. It is just not prudent. So, stay pragmatic. Don’t live beyond your means.
What if you can’t afford any of the homes?
The answer is you look at your other options. Maybe you can rent. Maybe, you don’t need to live in that area you really like and find another place where you can afford the rent. Suburbs perhaps where rents are cheaper? When my wife and I first moved to NYC, even though our combined income would have allowed us to live in Manhattan where rents were very high, we decided to live in Forest Hills, Queens as the rents were much cheaper. Yes, I had to commute and sacrifice a little, but the economic savings then outweighed the benefits of living in the city.
Related Topics
Interest Rates.
The artificially low interest rates in the last decade and the half have made the housing market more affordable. It means that the US has made the “fees” on owning a home artificially low so as to entice people to borrow more money.
So, let’s say you can borrow at 4% (but know that the actual cost is 8%), you would borrow at that low interest rate. It is cheap. On top of this, you can repay it for 30 years. But, if, however the rate is 8%, you’d think twice before doing so. This intervention by the Federal Reserve Bank has made the housing market the way it is. It is overvalued. Nuff said. The home prices you see on your block is the price of the home plus the loan and the low interest rate (which made home prices higher because of the increased demand for the houses).
Banks own your home.
When someone says he or she owns a house, they really don’t own a house. The bank owns that house. The moment you default on your mortgage, the bank assumes the ownership. Read the fine print, and you will know what I mean. So, what makes people do these things (super big homes, borrow galore, can’t really afford it)? I can think of a few reasons (actually, these reasons were shared with me by some friends in the real estate industry. One in particular was a former partner at Trammell Crow Company):
- Human nature. We have the tendency to want to be seen as better than others. The bigger the home, the more we look like we are doing well. Problem with this? Pride (ego) goes before destruction.
- Space. Some just really want the additional storage space and open areas. Problem? Cost of home goes high; too many toys and junk. Many of them are never used.
- Convenience. Many just don’t want to think about the hassle of the small to medium sized homes. Problem? You become complacent.
I am not saying to avoid the big homes altogether, but what I am saying here is purchase the big home for the right reasons: mix of need and want, and you can afford it.
Multi-generational wealth accumulation.
Even if one can afford it, I would still recommend living prudently. This has consequences on the generations to come. When children see their parents living large, they tend to get the idea that they are entitled to it, especially if parents do not teach their children how to work hard. If all they see is wealth and not the labor behind it, the parents are setting their children for a distorted perception of reality.
I know several people who are really wealthy but still live prudently despite all their successes. Their examples empower others to do the same. This brings a multi-generational wealth accumulation as the children or grandchildren learn the value of living within their means.