Is there ever a situation where buying an unaffordable house makes sense? A new report by real estate service Trulia seems to suggest so. The report notes that in some cities, Millennials should consider buying a house that is a little beyond their budget, given that they are likely to receive promotions and raises that will make it more affordable down the road. About the only worse advice I can think of would be for you to stick your hand in a rattlesnake’s nest.
The report is based on the assumption that in 30 years time, today’s 25 year-olds will be earning the same as today’s 55 year-olds, assuming a certain level of inflation. For example, the typical Millennial in New Haven, CT, can expect to spend 37% of their income on housing in the first year of a mortgage but, three years later, this will drop to 31% or less.
Ralph McLaughlin, a housing economist at Trulia, is quoted as saying, “There’s a sweet spot of metros where a mortgage looks obtainable but unaffordable, and yet it shouldn’t take long to become affordable.” In other words, it’s obtainable in the sense the person can get the loan, but unaffordable because it currently swamps their budget.
Given that mortgage payments are usually level payments spread out over the term of the loan, the actual mortgage payment doesn’t go down (and neither will maintenance costs or property taxes). Consequently, McLaughlin is assuming some significant promotions and raises for today’s Millennials.
But even if McLaughlin’s assumption is correct, and you can reasonably plan for a climb up the corporate ladder, does this mean you should buy a home today that you can’t really afford? Absolutely not.
This advice is premised on the idea that a home is a good ‘investment.’ Why else would someone buy more house than they could afford, unless they expect it to appreciate in value? Yes, you may find your house appreciates in value, and this plan might end up working out for you. But the recent property crisis should have erased any certainty in our minds that homes always increase in value. Further, even if they do, you might be better off putting that money in higher returning investments like stocks.
Instead, your primary residence should always be thought of as a consumption good and a living expense: no different than your expenses for food or clothing. There is nothing wrong with spending more on a nicer home, provided it is within your budget. But make no mistake, it is no different than spending more on any other consumption good such as cars or fancy restaurants.
The other assumption underpinning this analysis is the idea of the ‘correct’ or affordable percentage that housing should comprise in your budget. Around 30% of your income may be a good rule of thumb, as any higher percentage may make it harder to fund other necessities such as food and transportation.
Yet there is nothing magical about this number, and it quickly falls apart depending on your personal financial situation. For example, 30% towards housing may be easily affordable for one person, while even 20% may be unaffordable for someone with student loans, car payments and credit card debt.
Instead of a set percentage, why not choose your house as you would any other expense? For example, after you set aside enough for savings and retirement, the rest is left for living expenses, including housing. Therefore, a more expensive house means less to spend on other things like vacations.
On the other hand, economizing on a house means more for other expenses, or – better yet – more for savings. Think of how much extra money you can save and what kind of financial goals you can achieve if you only spend 15% of your income on housing instead of 35%!
It is true you should not buy a house unless you plan to keep it for at least 5 years, due to all of the mortgage and transaction fees. But even five years is not long compared to the span of a lifetime, and life circumstances change rapidly depending on marriage, kids and job location. There is no sense in buying a four-bedroom home when all you will need is a condo for the next five years of your life.
Millennials should stop thinking about housing as an investment. Nor should they think of housing as something they want to max out on budget-wise. Treat it like an expense to be minimized, don’t go over budget at the time of purchase, and there will be a lot less stress and anxiety. Do you really want to be in a position where you simply must have that next promotion just to afford the roof over your head?
Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.