Disclaimer. Buying a house is one of the biggest decisions in your life. It will fuck you up, if you make a wrong move here. Don’t trust anything you read on a personal blog of some random guy. Do the math. Think about taxes. Be smart. If anything can go to shit, it will go to shit. And it will happen at the worst possible time. But it will probably not be the thing you expect. So really, expect the unexpected.
How much house can I afford?
First, a quick heuristic:
Your rent/mortgage should be less than what you make in a week.
Second, another rule of thumb - the 28/36 rule.
1. Maximum household expenses shouldn’t exceed 28% of your gross monthly income. This includes everything within your home mortgage.
2. Total household debt shouldn’t exceed more than 36% of your gross monthly income. This is also known as your debt-to-income ratio.
Finally, a quote from Ramit Sethi:
Ideally the total price shouldn’t be much more than three times your gross annual income. (It’s okay to stretch here a little if you don’t have any debt.) And don’t forget to factor in insurance, taxes, maintenance, and renovations.
There are lots of home affordability calculators online, that let you plug in all the variables and calculate how much house you can afford. I used one by Vertex42, because it’s available for Google Sheets and I could edit and add things as I saw fit.
One more thing to know is that some banks give a maximum mortgage of 40% from your netto income.
Which seems like a lot, but if your salary is paid out once a year in a form dividends - that might be a problem, depending on the timing. You’ll also need to submit a lot more paperwork than a regular person with a “secure, stable job”.
Rent vs Buy with cash vs Mortgage
There are 3 basic options out there available when it comes to securing a roof under your head.
2. Buy (mortgage, bank gives you $).
3. Buy with cash (your dad/mom is rich, you bought Bitcoin at $50, etc.).
This post is not about renting, or its popular cousin “staying at your parents place”. Simply because for me personally, rent is out of the equation.
But just to cover our bases, the pros & cons of renting are:
[+] Not tying up cash in a down payment
[+] Not tying up cash in renovations, repairs and maintenance
[+] Potentially paying lower monthly costs
[-] No equity gains
[-] Can’t personalize; can’t even hang a picture sometimes.
“If you rent, you’re throwing money away”.
Let’s focus on “No equity gains” bit. This is just another way of saying that renters don’t benefit from rising home values. Homeowners do.
But these rises in home value are far from guaranteed. Rising home values come from 3 sources:
1. Principal reductions
2. Forced appreciation
3. Market gains
What’s the cost of these?
1. One requires opportunity cost. (You get more equity in your home, but you don’t invest this money elsewhere. Usually here people use 7% return from some S&P500 ETF as a benchmark).
2. One requires skill. (renovate cheaply to improve house valuation)
3. One is outside of your control.
Calculating Price to Rent ratio
Buying a house or apartment is a very personal, often emotional decision. It’s not a stock you invest in just to make money. Often it’s a place where you want to start a family or grow old. This sentimental aspect allows for some premium.
That’s why calculating P/R for your only residential property is not always necessary, but still it’s an interesting exercise.
Since this is mostly about comparing the ratio between different properties, the data needs to be homogeneous. The purchase price is used, not taking into account the interest you’d have to pay on mortgage. With rent, you exclude all utilities.
Looking at 3 apartments in Latvia and Lithuania, where I have this data —
One is 180,000€, rent would be 600€. So the Price to Rent ratio is 180,000 / (600 * 12) = 25.
Another is 125,000, rent would be around 500€. So the Price to Rent ratio is 20,83.
And one is 50,000, rent would be 300€. P/R is 13,88.
If you search for P/R ratios online, you’ll find a version of this rule of thumb to help you decide to BUY or RENT:
A price-to-rent ratio of 1 to 15 indicates it is much better to buy than rent; a price-to-rent ratio of 16 to 20 indicates it is typically better to rent than buy, and a price-to-rent ratio of 21 or more indicates it is much better to rent than buy.
Another analysis of price to rent ratio, focused on BUY or DON’T BUY:
If the P/R ratio is greater than 20, hesitate before buying the house.
If the P/R ratio is greater than 25, don’t buy the house unless you have strong non-financial reasons.
If the P/R ratio is greater than 30, run screaming in the other direction.
Another way to think about it is - the higher the ratio, the more you would need a spike in housing prices in the coming years to justify the price you are paying today.
But also, if for some reason people won’t be able to get loans from banks so easy, the demand side will drive rent up, which will also mean that P/R ratio is not set in stone and needs to be recalculated regularly.
For reference, here’s Chris Johnson writing about renting homes in St. Louis and Ohio:
Bought a few 30-40k houses that rent for $750 + in 2019 I even got one for $13,000 that rents for $600 Looking back it was a hella smart move
That’s a P/R of 4.44 and 1.8.
Here’s a graph of median P/R ratios in US for the last 30 years.
/USA Median Price/Rent Ratio/
On other hand, we have statements like this. Actual thing a smart person said to me:
“I’m paying the bank in mortgage payments less than what I make from renting out this apartment.”
Is this person taking into account the maintenance and renovation costs? As well as the real risk that rent might go down? Or is it the case of “My costs are only $600 per month. Oh, and once every 20 years, I pay an extra $55,000.”
Unexpected benefits of mortgage
For some people, mortgage is almost the only way to build equity. Poor discipline and personal finance skills will do that to a man. Or woman.
Why fixed rate 30 year loan is “the shit”
Fixed rate 30 year loan is the most terrific, very beautiful, tremendous product and “looks fantastic”.
[+] Inflation works in your favour (for example, you pay 500 today, 500 next year, 500 also 29 years later.) But it’s “different” 500. Remember how public transport cost 20 cents, now it costs €1.20. With time this will “feel” like a smaller payment, because of lower purchasing power.
[+] If you own your house (cash), and disaster strikes, YOU get to fight the insurance company. With mortgage it’s your bank vs insurance. Let them fight it out.
[-] Tied up cash in a non-performing asset. (missing out on the chance to invest X into something else, like an index fund.)
[-] Most people only live in one place for 6-9 years (these are US stats)
[-] Your down payment is not earning interest + you can’t easily access that money.
Oh and one more thing.
Unless you’re reading this from USA or Germany - fixed rate 30 year mortgage is probably not available to you.
In Latvia, it’s only available from those banks where you’re wondering if they will be around in 3 years.
Banks like Swedbank, SEB, Citadele - don’t offer them.
Fixed rate mortgages (FRMs) are dominant in Belgium, France, Germany and the Netherlands, while adjustable rate mortgages (ARMs) are prevailing in Austria, Greece, Italy, Portugal and Spain.
Reality in Baltics - adjustable rate mortgage
Reality is that your rate will be calculated from 2 parts. One is fixed, other is not. And the “adjustable” part is usually following 12-month or 6-month EURIBOR. Which is basically a rate at which banks lend to each other.
For example, you want to borrow money from the bank to buy an apartment for €126,000 and pay it back to the bank in 30 years. You’ll be asked to cover some 10-15% as down payment, and the rest, let’s assume it’s 107,000 - is the principle. Bank will tell you that the interest will be approximately €35,410. Here the assumption is that EURIBOR will be 0 throughout the whole period (that’s 30 years).
But that’s a very big assumption. It’s 30 years. A lot of things can happen in 30 years. I very much doubt that EURIBOR will stay negative for 30 years.
/Historical 12 months EURIBOR/
Following the previous example, if you took €107k in mortgage with a 2% interest rate + EURIBOR, so far you’ve been enjoying a monthly payment of €382.
If EURIBOR reaches 3%, congratulations, you suddenly need to pay €167 more. Every month. If it gets to 5%, that’s almost €300 more.
So there you were, paying €382, life was good. But if EURIBOR will be at 5%, you’re suddenly paying €682 every month. Shit.
That sucks. What to do?
If the option to refinance in another bank with a fixed rate appears - take it.
Otherwise, wait and see when EURIBOR will become positive.
Banks don’t recalculate the rate every day or even every month, it’s usually done once a year. In my case - once a year, in the middle of September.
So you will have a heads-up that your new rate will be higher for some time in advance.
Depending on how big EURIBOR is, I see 2 options.
Do the math and try to understand if it makes sense to pay out the loan as fast as possible, liquidating other assets. Depends on how well the other assets are doing at the time too. It sucks, because most likely these are cash-producing assets, while owning an apartment you live in - is not.
Or try to gradually pay out the whole thing, paying out something like +20k per year, to pay out mortgage “faster”. But it’s often not the best idea.
If that’s not a viable option, or math doesn’t add up … just deal with it. Accept this as your new reality. Submit to your € masters.
I like this thread by Ron Caruthers on Twitter — Which mortgage is the ‘best’ according to math, science and financial planning principles?