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Are you considering purchasing a home and wondering how much house you can afford?
For many of us, homeownership is a lifestyle aspiration as well as a huge financial decision.
It feels great to be free of the landlord. To know your home is your own, and you can stay put as long as your like. The larger payments that normally come with a mortgage and inflexibility are the downsides.
I’ve written before about reasons not to buy a home, and how to save your deposit if and when you buy. I think it’s becoming more common knowledge that buying a home is not always the best financial move.
So How Much House?
One of the first questions first home buyers tend to ask when they have decided they want to buy a home is how much house to buy.
The easy temptation is to start by working out how much you could qualify to borrow. But this is not the best way to go about this life-changing decision.
Your overarching financial strategy should be front of mind when deciding how much house to buy. Instead of buying a house consistent with the amount lenders will lend you at the time, there are two valuable strategies in approaching home purchasing:
- Buy less than you can afford to keep cashflow free for investing, travel, freedom
- Buy as much as you can possibly stretch to maximise capital tax free growth
Of course, there is plenty of room in between for intermediate strategies, but I think deciding which extreme your own property strategy falls closest to is a good start.
Strategy 1. Buy as Much home as You Can Possibly Stretch to.
This is the traditional strategy. The idea is to max out your borrowing capacity to buy the best house (or the worst house on the best street). The strategy often involves upgrading your property every few years, to take advantage of your growing salary and to leverage any equity you have gained in market movements. Over the years, you able to purchase houses in better and better streets.
Many of our parents followed this strategy, and it worked out well for many. The idea goes that property is a great investment, and will grow in value over the years. At the end of your career, you can sell your (hopefully) massively appreciated house without any taxes and downsize to free up cash for retirement.
Any gains are currently tax-free as long as you live in the home as soon as practicable after your purchase. There is even a 6-year rule. This means you can leave the property and live elsewhere and continue to treat it as your principal place of residence. Despite being absent from the home for up to 6 years, you can protect your capital gains tax exemption on sale. As long as you check with your accountant and make sure everything is done and documented properly.
-Strategy 1: If you Pick a Property Poorly, the Strategy Fails
This strategy works incredibly well if you purchase a property(s) that ends up delivering fantastic capital growth. The dangerous “rule of thumb” that property doubles every 7-10 years imply this growth occurs to all properties. Some properties grow in excess of this, some don’t grow at all.
Sydney and Melbourne property prices have historically performed far stronger than the rest of Australia, which is why these cities are so unaffordable. The rest of Australia has not done so well. Up until this latest property boom, our property value in a regional town has just about matched inflation since we purchased.
If you pick the right property, in the right suburb and in the right city. But if this home is your single retirement plan (as it was for my parents), there is a whole lot riding on your choice! This is an example of concentration risk – all your eggs in 1 expensive basket.
Even if you choose a location that has historically provided great capital growth, there is no guarantee this will continue. If you maximise your leverage into a home in Sydney, what if Sydney lies dormant for the next 20 years whilst Melbourne booms?
– Strategy 1: You Get to Live in that Dream House
If you aspire to live in a prestigious area, and you get the investment part right, you are fulfilling an investment and lifestyle goal in one. You get to live (eventually) in your ideal home, and then it pays for your retirement. Sounds like a dream!
Inevitably though, few people can afford their actual ideal and still have to make some compromises. But you should definitely get an absolutely lovely home with this strategy
Strategy 1: Tax
The fact that this strategy means all your gains remain capital gains tax-free is attractive. You need to move into the property as soon as that is possible or you lose your capital gains tax exemption altogether. So no renting it out for the first few months, or delaying moving in after settlement.
Unfortunately, interest paid on own home is non-deductible. This means you are footing the entire interest bill for the duration you own your home. We currently have record low-interest rates, which makes this considerably less painful. But assuming interests rates eventually rise, your capital growth needs to increase faster than your annual interest rate.
Strategy 1: Reducing Options & Financial Stress
Having a mortgage repayment eating up half of your take-home salary drastically reduces your options in life. You cannot take a pay cut by changing jobs or reducing hours. You will probably not be able to invest money elsewhere for several years.
The reason I personally don’t like the idea of this strategy is from watching my own parents struggle for years. My father worked 7 days a week for decades! I wanted a different sort of lifestyle for our growing family.
If buyers can get through the first few years (the first 2 are the highest risk), financial stress tends to reduce. Those expecting a large pay rise in the near future may be tempted to push the borrowing in the short-term reassured that income will soon increase.
Those that don’t have 100% secure income or plan a reduction in income in the next few years (parental leave) need to take this into account when working out how much house they can afford.
Strategy 1: How Much House – Remember Interest Rates Do Go Up!
Mortgage repayments don’t look so bad with today’s low-interest rates. But they won’t stay low forever. Borrowers have the option of fixing rates, which can reduce risk significantly for tight budgets over the first 2-3 years. But once your fixed rate expires, you are at a mercy of interest rates at the time.
Our household purchased our family home in 2008, paying an interest rate of around 8%. Since then, interest rates have gradually dropped making our (less than we could afford anyway) mortgage less expensive over time. I buying a home and then experiencing interest rates inch all the way back to 8% over the next 10 years would be stressful.
-Strategy 1: The Downsizing Plan
Many who have followed this strategy have then struggled to downsize when the time came.
After many years living on the best street, it can be hard to downsize or move to a less prestigious suburb.
My parents brought the biggest and best house they could possibly afford. They were under financial stress for many years trying to pay the debt down. By the time they were ready for retirement, they were used to (and very proud of) owning a big, lovely home on a good street. The thought of downsizing to anything less prestigious was unappealing!
Strategy 2. Buying Far Less Home than You can Afford
This strategy works far better for those buying in a town not likely to see above-average returns. It also works well for those that want to have money left over for holidays, time off for kids and retirement. In lower house values areas, you also get a lot more house for your money so it doesn’t necessarily mean living in a suboptimal home.
There has been recent news about tightening lending conditions again. A borrowing maximum of six-time gross income has been suggested.
On a $150,000 gross salary, 6 x borrowing would be $900,000.
Repayments on $900,000 over 30 years at 2.99% would be $3790, or ~40% of net income assuming the income was earned by a single worker. That seems like enough of a mortgage to me!
Yet according to this financial review article, recent average loans in Sydney are written based on 8x salary! Even a tiny movement in interest rates makes these loans impossible to pay (hopefully they’ve fixed rates).
With Sydney and Melbourne prices, borrowers have been pushing these limits just to get into the market. If they have selected a great property, fingers crossed it will pay off.
In a regional city you may be able to get away with only borrowing half your potential borrowings.
– Strategy 2: Missing out on Capital Gains
The big opportunity cost here is if you plan to live and work in an area that will benefit from a significant capital gain over the next few years. It is important that if you choose the smaller mortgage, you use the extra cash flow consciously on something that will give you long-term value.
– Strategy 2: Missing out on Living in the Dream Suburb
If the prestige of living in THE suburb to be in is something that appeals to you, this is something to weigh up. Perhaps you won’t live as close to cafes and restaurants, or have your colleagues on your street. The benefit of living in a more average suburb includes less pressure to “keep up with the Joneses”. If you purchase on the street of your dreams, you may find you NEED to upgrade your car, and dress in more upmarket identifiable labels.
– Strategy 2: Spare Cash Flow Potential
Your extra cashflow freed up by buying less house than you can afford can be put towards investing or lifestyle goals (or both). Options include:
– Paying the mortgage down
A worthy and low-risk goal. Increasing your equity will allow you to borrow off this if you want to invest in property in a few years time (which feels like hitting two birds, one stone).
If you invested this money in the stock market, you would need to pay tax at your marginal rate on any dividends or withdrawals. So your returns need to be good enough to beat your mortgage interest saved after tax. That shouldn’t be too hard over the long-term at current rates, but as interest rates increase, paying down your mortgage becomes even more attractive.
When “paying off” your mortgage you may like to fill an offset account rather than actually pay down the loan. It has the same effect on the interest paid (less and less as you fill your offset) but the money still legally belongs to you, not the bank. This means you can withdraw it if in financial distress when the bank could prevent you from redrawing. It also provides flexibility if circumstances change (a new job offer in a new city?) and you decide to convert your home into a rental property. The offset cash can be withdrawn and used as a deposit on a new PPOR (or for whatever reason) and interest on the remaining loan balance remains tax-deductible.
– Purchasing an Investment Property
You are probably not going to be able to immediately purchase an investment property after buying a home, but with an aggressive pay down strategy and a booming market like currently, you could be ready to go pretty soon.
Interest on investment properties, as opposed to your principal place of residence, is tax-deductible.
Between renters and tax incentives, this makes owning a 500K home and 500K investment property potentially more profitable than owning a 1M home. The renters are helping significantly (particularly at current interest rates) and any shortfall is further softened with a tax deduction.
Owners of a 1M home pay every bit of the mortgage themselves, with no help from the Australian Tax office.
Interest rates are often slightly higher on investment properties (mine are 0.6% higher) than homes. And you lose out on the capital gains tax exemption you would get on the 1M home (although you would still receive it on your more humble 500K home). You would receive a capital gains tax discount of 50% on your investment property if you kept it for a year or more. And you pay no capital gains tax on an asset you never sell.
Automated investing into your superannuation or index fund ETFs outside super
This is easy and ideal for busy professionals who don’t have the time or interest to do significant research. Your super will allow you to direct debit extra payments directly into the fund, brokerage fee. Keep in mind that you will not be able to withdraw until your preservation age, so don’t invest so aggressively in super you are left short.
Those wanting to retire earlier than their preservation age (keeping in mind that may change) or those with a long term non-working (on the 0% tax bracket) adult at home may want to invest outside super. This will take a little research but is pretty easy to organise and automate through Pearler*.
– Holidays and travel
You may be purposely avoiding over-commitment to a huge mortgage to include more fun in your life. This may be more eating out, buying nice things or going on awesome holidays. Spend on what you value and brings you joy. Just put a little aside to do the grown-up thing and save a bit too.
How Much House Can I Afford?
How much house you can afford depends on your:
Current gap between income and spending plus rent paid –
Find out your net income, and work out what you actually spend, not a budget based on a hypothetical idea. Use expense tracking to work out what your actual expenses are. Your bank is going to examine (with a fine-tooth comb) your real-life spending using bank statements so you might as well get to grips with reality.
How Much House: Income security and anticipated income changes
Do you have a permanent contract? Doctors are often on temporary contracts for many years, but banks do seem to accept this as a norm. You could negotiate a longer contract with your employer to provide yourself and the bank extra reassurance.
If you are hoping to start a family or reduce income in some other way in the next few years, make sure you take this into account. Make sure you aren’t committing yourself to financial stress during anticipated times of reduced income.
Do you have income protection insurance, or will you qualify for a policy large enough to cover your intended mortgage? Unfortunately those with significant “pre-existing conditions” will often struggle to get cover. If you or your partner suffer an illness or injury that prevents them from earning an income for a significant period of time, there needs to be a backup plan.
It is a good idea to have some cash sitting in the bank in case of emergencies on settlement day. The last thing you need after spending every dollar on that dream house is for the car to need a major repair, or the hot water system to blow up and need replacement.
Priorities for the future
This involves a bit of daydreaming. Set audacious goals and design your ideal life. What is most important to you? Incredible house or incredible holidays? Intended retirement age (do you need to invest extra)? Is getting mortgage-free important to you?
Almost no one can have everything. You have to prioritise what you really want to make sure you get it!
Area you want to live in
How confident are you of its capital growth potential? Are you happy to bet the (literal) house on it? Is it in a major capital city within the commuter belt? Is it an established house (new homes and high rise units seem to perform poorly)?
How Much House Can I Qualify For?
Only after answering the above questions should you work out whether the bank will lend this money to you. Your ability to borrow depends on;
What is your gross income, easy to find on the ATO website. Banks will want at least 6 months of payslips or two years if self-employed.
– Security of income
Permanent employee > temporary employee > self-employed.
I was questioned about my income protection, total permanent disability and life insurance by the bank during the latest property purchase. If anything terrible happens to you, the bank wants to know you will still be able to repay your loan.
-Gap between Income and Spending
If my recent experiences applying for a mortgage are anything to go by, they are not going to take your word for it. They will ask for every bank statement you have ever received. One at a time. A couple of times each.
OK, maybe I’m exaggerating a bit. But your pie in the sky budget (that never foresees the emergency car repair, dental treatment…) is not going to cut it.
If there is a reason to keep your banking simple, this is it. Being asked for statements on 9 accounts repeatedly is really annoying. Sorry Barefooters!
– Other borrowings
These make a big impact on your borrowing capacity. Credit card limits are treated as if you have maxed out your card and need to make minimum repayments. Even if you pay them off every month religiously. If you’re anywhere near your borrowing capacity reducing card limits or closing unused cards and accounts may be worthwhile. Check with a mortgage broker.
– Credit score
You can apply for your credit report from Experian and monitor it monthly on Creditsavvy. I did have one random application appear on my file, which was erroneous. I managed to get it removed but had to be pretty persistent with the company involved.
Certain professions are considered ultra low-risk borrowers because as a group they rarely default on loans. These include doctors, accountants, lawyers, dentists. Many banks will allow high borrowing (up to 90%LVR) without charging lenders mortgage insurance which is a big bonus.
How much deposit have you saved? You will generally need at least 5-10% of the purchase price plus ~6% buying costs.
Banks have become much less keen to lend to those they don’t see having enough working life to pay off the mortgage. A colleague was questioned (and offended!) by the bank about her plans to pay off the debt despite her advanced age (45!).
How Much House to Buy?
This is a very personal question, which depends on your capability of paying back over the next 30 years as well as your priorities. Do yourself a favour and spend some time reflecting on these questions (with your partner if you’re buying as a couple). Make the right decision for yourselves.
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Aussie Doc Freedom is not a financial adviser and does not offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.