buying a house and cashflow

Buying a house – start by understanding your cash flow

In Buying a Houseby Phil McGilvrayLeave a Comment

Buying a house – working out what you can afford

So, you want to buy a house but have no idea what you can afford?

In this article I will take you step by step through the exact process I use with all my clients to help them work out work out what they can truly afford to spend when buying a house.

The great thing about this process is that my goal is not to give advice, but rather to let the numbers speak for themselves.

 

Meet Colin and Kate:

Colin and Kate are a young couple in their late 20’s; they have been renting for 5 years and over that time have managed to save $135,000.

The owner of the house they have been living in is unfortunately moving back to Australia in 3 months’ time and they will have to move out. They came to me to help them work out if they could afford to buy their own home, and if so what could they afford to pay.

So here is the process I took them through:

 

Step # 1 – What do you really want your life to look like?

The first step in this process was for Colin and Kate to work out what they really wanted their life to look like.  

If you want to travel, start a business, change careers or be a stay at home mum, you need to be clear on how these things fit with taking on a mortgage.

Don’t just take snapshot of today, project forward a few years and realistically assess what impact owning a home and having a mortgage will have on achieving your other life goals.

 

Step # 2 – Work out what the probable purchase costs will be

Buying a house is an expensive process; depending on the size of your deposit, purchase costs typically equate to between 5% and 10% of the purchase price.

Working out the costs involved with buying property is important because it will enable you to work out how much of your savings will be left to put towards a deposit.

Colin and Kate were hoping to buy a house in the $400,000 to $500,000 range. They wanted to put down a 20% deposit which would avoid Mortgage lenders insurance and mean their purchase costs would be approximately 5%.

At 5% their purchase costs would be $20,000 to $25,000.

I also strongly recommended that on top of the purchase costs, Colin and Kate set aside at least $10,000 as a cash reserve. Houses are big and expensive and when things go wrong, and they do, it can cost you thousands of dollars.

With cash reserve included, Colin and Kate set aside $35,000 for potential costs.

 

Step # 3 – Work out how much your deposit will be

With $35,000 set aside for costs, Colin and Kate were left with $100,000 to put towards a deposit which meant that their maximum price was definitely set at $500,000 in order to put down a 20% deposit.

The next big question to answer was – what sort of loan would their cash flow comfortably support?

 

Step # 4 – Consider your income both now and in the future

The first step in figuring out what sort of loan your cash flow can support is to define what your income is. This is crucial because, like it or not, your income provides the upper boundary for your spending. When it comes to income you are looking for 2 things:

  1. Income that is regular – in other words income that you receive every week, fortnight or month. Anything less frequent makes it very hard to factor in to your cashflow and home loan repayments.
  2. You need to be conservative in your calculations. If you receive overtime, shift penalties or bonuses make sure you are realistic about what you really receive – don’t just shoot for the best-case scenario. If possible, use your base income without the penalty rates.

Can I also really encourage you here to not just take a snapshot of your income here and now but also give some considered thought to future life events like starting a family or changing jobs and how that might impact on your income.

In Colin and Kate’s case they we both regular employees with fortnightly salaries. Colin earned $1,571.53 / fortnight and Kate $1,359.63/fortnight.  Their total income household income came to $2,931.16 / fortnight.

Step # 5 – Have a comprehensive understanding of your expenses

This is the big one – take time to identify all your expenses, when I say all, I mean ALL – not just the bills! You need to know what all your variable / discretionary expenses are too. You know, things like groceries, petrol, gifts, hobbies, sports, clothes, haircuts, pets, entertainment etc.

To help you do this you can download my budget worksheets here and complete the following three tasks:

    1. For 30 days record every dollar you spend so you get a good feel for where all the little bits go – things like groceries, bought lunches, coffees, takeaway etc
    2. Go back through 12 months of bank and credit card statements so you know what your expenses are, how much they are and how frequently they occur.
    3. Complete the gifts list in the budget worksheets to help you identify how much you spend on gifts over the course of a year.

It took Colin and Kate about 2-3 hours to go through this process and complete the budget worksheets. I went through the expenses with them to make sure what they were allocating to their expenses was realistic.

 

Step # 6 – Convert both your income and expenses to a monthly figure

Now that you have a thorough list of your income and expenses, you need to convert them both to a monthly figure so you can make an apples to apples comparison.

The easiest way to do this is to first convert each income source and expense to an annual figure and then divide it by 12 to arrive at a monthly figure ie.

 

Step # 7 – Make a direct comparison between your income and expenses

This is your moment of truth; this is where you make a direct comparison between your income and expenses. This simple process will tell you if you have a surplus or a deficit and exactly how much that surplus or deficit is. Below you can see Colin and Kate’s position summary in their current situation as renters.

Their average monthly income is $6,368.30 and their total monthly allocation to all their expenses is $3,961.23 leaving them with an average monthly surplus of $2,407.07.

Please note Rent is included under utilities in the above budget example.

Once you have your expenses listed out like this you can then play around with the numbers and figure out exactly how much capacity you have for mortgage repayments.

But before you do this you need to:

  1. Remove rent as an expense (for Kate and Colin this was $434.53 / month)
  2. Add in estimated council rates ($1900 pa = $158/month)
  3. Add in estimated building insurance ($1,100 pa = $92/month)
  4. Add in approx $200/month for household up keep ($200 /month)
  5. Add in estimated water charges ($50/month)

The net result of these changes was that Kate and Colin’s surplus / available funds dropped from $2,407.07 to $2,341.60. This is how much they theoretically have to allocate towards mortgage repayments, however ……

 

Step # 8 Always leave yourself with a buffer

While Kate and Colin have an average monthly surplus of $2,341.60 it would be foolish to commit all of this towards mortgage repayments.

You should always build in some buffers because budget blow outs, expected expenses and emergencies do occur. So here are the minimum buffers I recommend to all of my clients:

  1. Budget buffer – Firstly do not commit all of your monthly surplus to potential mortgage repayments you should ideally leave yourself with potential savings capacity of at least $500/ month.Please believe me as a budget coach I know it is very easy to over spend on your budget by $200 – $300 every month, so giving yourself a buffer of $500 should be the bare minimum.For Kate and Colin this meant that that the funds available to put towards a mortgage dropped from $2,341.60 to $1,841.
  2. Interest rate buffer – around the world interest rates are at historical lows; they will not stay this low. When you are working out potential mortgage repayments always add at least 2% to the existing variable loan rates.If you think I am joking about this, check out this article.http://www.abc.net.au/news/2017-08-21/how-interest-rate-rises-could-affect-home-loan-stress/8798274Based on this article 1 in 3 mortgaged households would be in mortgage stress if interest rates rose just 0.5% from current levels and half of mortgaged households would be in mortgage stress if rates rose 2% to a level seen just 5 years ago.Don’t become a mortgage stress statistic; factor in at least 2% on top of the current variable interest rate.For Colin and Kate we used an interest rate of 6.0% which is 2% above the current variable interest rates offered by the major banks.

 

Step # 9 Use a mortgage calculator to work out what size mortgage you can realistically afford

Now that you know how much money you can safely put towards a mortgage payment you can work out what size mortgage you can truly afford using mortgage calculator.

A snazzy little calculator I use all the time with clients can be found at https://www.yourmortgage.com.au/calculators/repay_advanced/

Based on Kate and Colin’s available surplus of $1, 841 and an interest rate of 6.0% we are able to calculate that in a 30 year loan term they could afford a mortgage of $305,000

Step # 10 – Final calculation – how much can you afford to spend on buying a home?

Now it is time to put it all together.

In step 2 and 3 we calculated that based on a price range of $400,000 and $500,000 Colin and Kate’s purchase costs would be between $30,000 and $35,000.

This included a $10,000 cash reserve for the large unexpected costs that go with owning a home.

Given their savings of $135,000 and anticipated purchase costs of $30,000 to $35,000, Colin and Kate have between $100,000 and $105,000 to put towards a deposit.

Then in step # 9 we identified that they can comfortably afford to service a mortgage of $305,000.

Adding together their deposit of $100,000 to $105,000 and a mortgage of $305,000 gives Colin and Kate a maximum purchase price of $410,000.

 

So, there you have it the 10 step process I take all of my coaching clients through to help them work out what they can truly afford to spend on a new home.

Buying a home will most likely be the biggest purchase you will ever make so can I encourage you to take off the rose-tinted glasses for just a while and invest 3-4 hours objectively working out what you can really afford.

No house is worth the financial stress that come is with stretching yourself to far!

 

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