The title of this article is bound to ruffle some feathers – in fact, I would expect that many real estate agents are bristling as they read this. However, I believe whole-heartedly that before you speak to anyone about purchasing a new home, you should speak to a financial advisor.
Of course, I am a financial advisor, so that is clearly a biased and self-serving statement. But that doesn’t mean it is wrong. Whether you are in the market for a new home or just reading this for informational purposes, you likely know that the residential real estate market has been explosive the last few months. In May of this year existing home prices hit a record, rising 24%, apparently on the back of COVID-19, increasing commodity costs, and historically low interest rates . Inventories of homes for sale are being described as at an all-time low, and whatever houses do hit the market are often sold within days to above ask, all cash, no contingency buyers. If you need or want to purchase a new home, it is easy to get caught up in the frenzy of the moment and find yourself rationalizing these actions. That’s where a financial advisor can add valuable perspective.
From a financial advisory standpoint, buying a new home involves investing, financial planning, risk mitigation, and cash flow management. It can affect practically every facet of your financial existence (cash flow, taxes, retirement, insurance, education funding, philanthropy) because a home is often a family’s greatest asset, their mortgage their greatest liability, and their monthly housing payment their greatest expense. It ticks many boxes that we are concerned with when developing a financial plan. So why don’t people rely on a financial advisor to help them through the process? Where could we logically fit in?
Let’s start at the beginning. If you decide you want to purchase a new home, you would likely ask yourself questions about location, size, and configuration. These are questions you ask yourself based on preference, family size, and a host of other issues. But I believe an equally important initial question to ask is “what can I afford?” It’s great that people ask that question, but unfortunately, they often ask the wrong person. Who should you ask? I would say your financial advisor. Who do most people ask in my experience? A mortgage broker.
Many mortgage brokers are great at what they do, but their job isn’t to understand your financial circumstances; it is to underwrite the loan for largest possible amount. This should be obvious – brokers are paid a percentage of the loan so are incentivized to write larger ones – but most people don’t realize that when they start the process. When you ask a mortgage broker what you can afford, they’re incentivized to look at a small portion of your financial picture – typically only what is on your credit report – and calculate a ratio of your monthly debts to monthly income. If your expenses are low relative to your paycheck, congratulations, you are approved. If they are too high, the broker will work with you and identify debts to pay down. Ultimately their goal is simple: get you just below the maximum threshold so they can get you as big of a loan possible.
Financial Advisors use these same ratios but with three major differences – scope, time horizon, and level. Scope refers to what is included when you start doing calculations, i.e., what kinds of expenses are included as “debt”. For Mortgage Brokers it is simple: anything on a credit report. Anything outside of that isn’t technically contractual, so it doesn’t have to be included. What does that leave off? Well, a lot, frankly. Food, utilities, gas, clothing, kid’s activities, daycare/school…the list goes on. While a credit report usually captures the largest and longest of a person’s liabilities, it is NOT comprehensive. A budget developed by a Financial Advisor, however, can include all these things and provide a more holistic debt-to-income picture.
The second issue is the time horizon. When underwriting a mortgage, lenders are concerned with your financial picture as a snapshot in time. They want to make sure that on the closing date everything is as it should be. But for those of you reading this that have a mortgage – has the bank ever followed up a few years later and asked if your DTI was still at a certain level? Of course not, and that is because what happens after the loan is approved doesn’t matter to the bank if you are making payments. I believe this is incredibly short-sighted. If you are purchasing a home with a mortgage, you are undertaking anywhere from a 15 to 30-year commitment. It is one of the greatest financial obligations an individual or couple can volunteer to accept. In many cases, it should be considered the cornerstone of your financial well-being with lasting consequences, not as a short-term transaction.
I believe the final issue, level, is most critical. A recent article in the Wall Street Journal revealed that “in the current lending environment, there are banks that will lend you in some cases up to 50% of your gross income ”, meaning your housing payment represents half of your pre-tax paycheck. To put this more simply, if your monthly paycheck is $10,000 before taxes, you could buy a house that requires a $5,000 per month payment. That is outrageous. The typical guideline for a monthly housing payment – or what is termed “House Ratio 1” – is no more than 28% of gross pay. In my view, that is the maximum a reasonable financial plan would budget strictly for principal, interest, taxes, insurance, and HOA fees for a home mortgage. So, in the current environment, some banks are willing to loan individuals almost TWICE as much as is financially responsible for the purchase of a home.
Does that mean that everyone who gets a mortgage at high DTI ratios is bound for bankruptcy? No, absolutely not. Banks are incredibly skilled risk managers and the 2007-2009 housing crisis taught them some very painful lessons. When a lender provides a loan, they should have confidence the individual will make the required payments. But that is all they appear to be concerned with – the required payments on the LOAN. As mentioned earlier, a new home can affect many aspects of your financial life; if you are spending half of your gross income on housing, will you be able to fund your retirement? What amount will you put aside for your children’s education, and will that be enough to pay for what you envision? Will you be able to afford a new car in a few years, or an annual vacation? How long could you afford to stay in the home if you lose your job or are injured?
I believe these are questions that can only be effectively answered by someone who has a holistic understanding of your financial situation. Every financial decision you make, especially large ones like purchasing a house, are intertwined. Nothing happens in a vacuum, and the extra $500 per month you might spend on a home could be the reason you retire years later than you want. Before you make a decision that will have lasting consequences for you and your family, make sure you are consulting with an advisor who has the whole picture – speak with your financial advisor.
While information presented above is believed to be factual and up-to-date, Aviance Capital Partners, LLC (“ACP”) does not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Due to various factors, including changing market conditions, the above information may no longer be reflective of current positions or recommendations. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Viewing this article does not serve as the receipt of, or a substitute for, personalized advice from ACP or its affiliated investment professionals. Readers should not use any of this content as the sole basis for any investment, financial planning, tax, legal or other decisions. Rather, a professional adviser should be consulted and/or independent due diligence should be conducted before implementing any of the options referenced above. Additional information about ACP, including its Form ADV Part 2A describing its services, fees, and applicable conflicts of interest is available upon request and at www.adviserinfo.sec.gov.