Do Low Interest Rates Change the Rules for a Mortgage?

A lot of different “rules” are passed around regarding the size of a mortgage that a person or a family should take out in order to afford a home.

One common one I see and hear repeated is that you should never take out a mortgage that has a value of more than twice your annual income. From what I can tell from my research, this one originated in the book The Millionaire Next Door by Stanley and Danko.

Another “rule” I’ve seen on this subject is that you should never obtain a mortgage with monthly payments that exceed 25%/28%/30%/32% of your monthly household take-home. The percentage tends to vary quite a lot.

I think both of these rules make sense in different ways.

The first rule does a good job of protecting potential homeowners from all of the additional expenses that come with home ownership that first time homeowners might not anticipate: maintenance, repairs, homeowners insurance, property taxes, association fees, and so on.

The second rule does a good job of making sure a family’s monthly cash flow isn’t too clogged by a mortgage payment.

So, which one is the right one to follow?

Let’s look at the example of the Slotkins. The Slotkins make $80,000 per year, which means the family brings home somewhere around $4,500 per month.

Under the first rule, this family should not take out a mortgage for more than $160,000. That’s easy to calculate.

The second rule varies a little bit, so we’ll stick with the 30% version of the rule to make the calculations smooth. This means that their mortgage payment should not exceed $1,350 per month. In a world where that family can get a 30 year fixed rate mortgage with a 6% interest rate, they can borrow $225,000. On the other hand, if they’re looking at a 3.5% interest rate, they can borrow $300,000 and still make a monthly payment just shy of $1,350 a month.

For comparison’s sake, if they can get the $160,000 mortgage at 3.5%, their monthly payment will be $720.

If we assume that the families have a down payment of 20% of the value of their home, they can buy a $200,000 home in the first example, a $270,000 home in the second example, and a $360,000 home in the third example.

Now, here’s the tricky part, and it’s why I tend to lean toward the first rule regardless of interest rate.

Let’s say that home maintenance will cost 1% of a home’s value per year, which is a standard estimate. Let’s also say that insurance will cost 1.5% of a home’s value per year, and we’ll put property taxes at another 1.5% of the value of the property per year. That’s 4% per year that they’re going to have to come up with. All of these numbers scale based on the value of the home, so you can quibble a bit with the percentages depending on the value you find, but the principle remains true.

On the $200,000 home, the family will have $8,000 in annual repair, property tax, and insurance expenses using the numbers above. That equates to $666 a month in additional costs.

On the $270,000 home, that number jumps to $10,800 in annual costs. That’s an extra $900 a month.

With the $360,000 home, the number leaps up to $14,400 in annual costs. That’s an extra $1,200 a month.

So, what’s the monthly cost for each of these examples?

With the $200,000 home, with a 3.5% interest rate loan, the family is going to be spending $1,386 a month on all of the costs associated with their home. That’s around 30% of their $4,500 monthly take-home.

With the $270,000 home, with a 6% interest loan, the family is going to be spending $2,250 per month. That’s 50% of their $4,500 monthly take-home.

On that $360,000 home, with a 3.5% interest loan, the family is going to be spending $2,550 per month. That’s 57% of their monthly take-home, which leaves them with less than $2,000 per month for all of their other expenses.

Here’s the reality: a low interest loan can get you in the front door of a more expensive home, but that low interest loan does not reduce all of the other costs associated with home ownership. If you’re using a low interest loan to push yourself into a house you wouldn’t be able to afford with a higher interest loan, you still can’t afford it because all of the other costs – insurance, property taxes, and so on – will be higher anyway.

Yes, the more expensive home might be worth more and might build more equity than the lower cost home, but you’re putting yourself on a very precarious financial tightrope. If you lose your job or someone falls ill and you lose that house, you’ve lost all of that extra money you’ve thrown into insurance and property taxes, too. It’s a big risk, one not worth taking with your primary residence.

Given that, I prefer the rule from The Millionaire Next Door: never get a mortgage that totals more than twice your annual income. It doesn’t matter what the interest rate is. Instead, view a lower interest rate as a personal opportunity to save more money for other purposes and for investing.

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