The other day I had a great learning experience when working with one of our clients. Our client was deciding whether or not he and his wife could afford to purchase a new house, and reached out to me to learn if he was financially prepared. Unfortunately, after reviewing his situation I told him he was not able to buy a house because he was carrying other debt that would hold him and his wife back from having any flexibility with their income streams. It was the perfect example of why we need to be careful with how much we leverage ourselves with debt.
At Wela, we follow the TSL budget - Taxes, Savings, Life. It's a rule of thumb that says that you should spend 30% of your income on taxes, 20% on savings and 50% on life. If you are able to maintain this rule of thumb, then we believe you are in a solid financial position.
The family I was working with brings in about $100,000 a year. They wanted to buy a house, and the price of the house was actually a steal. The mortgage payment would be well within reason based on what they make each year. The problem was that they are currently servicing other debts - student loan and credit card debt - which has a monthly payment that is only slightly less than the current mortgage payment. If they were to buy the house they would be putting 36% of their income, $36,000 every year, towards debt servicing. This is in the maximum range of what we feel comfortable with at Wela. So, I had to tell him that from a financial standpoint it wasn’t a smart decision to buy the house.
We always try to figure out how to balance both consumption and frugality at Wela, but sometimes it just doesn’t work. The reason it doesn’t here is because if they bought the house and had that much debt to service they would be tying up too much of their after-tax income to debt servicing. They would be putting themselves into a situation where they'd have to incur more debt in an emergency which would be a major financial setback. The best thing for them to do is to really focus on paying off their debt as aggressively as possible. Instead of putting money towards a mortgage, they need to put their extra cash flow towards reducing their other debts as quickly as possible. We recently released an ebook on starting a 30-Day Economic Shutdown. This could be a good way for this family to jump-start debt reduction.
Let's look at this family's proposed budget in terms of the TSL budget. If this family had 36% of their income going towards debt servicing along with 30% going towards taxes and even just put 10% towards saving, they are left with a minimal amount of cash flow for living expenses like buying food, gas, car insurance, utilities, etc. On top of this, if they own a home then they also have maintenance costs. Heck, on $100,000 income we are talking about having $2,000 a month for life expenses, and they are already spending about $1,700 on necessities outside of rent. On top of all of this, the couple is currently expecting their first child. These numbers just make their budget too tight. Could they buy the house even with the other debt? Yes, but it would really squeeze them, and the first mishap that arises with the house or anything else could likely lead to them incurring more debt.
This example just shows that even if you are able to borrow… like this client who would likely be approved by the bank for the mortgage… doesn’t mean that you should borrow. The ability to borrow money versus if you should borrow money are two drastically different situations and deserve two different criteria. Here is a situation where they could borrow, but they shouldn’t.
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