Do you ever drive through a neighborhood of million dollar homes and wonder how on Earth people afford them?
To paraphrase comedian Steve Martin, here’s how you buy a million dollar house. First, get a million dollars.
But seriously, folks. Buying a million dollar home is no different than purchasing a $100,000 house. It’s all about Priorities and Math. You gotta get both parts right for your seven-figure abode to be a sound financial move.
Priorities: Let’s first talk about priorities. Why exactly do you want this expensive crib? Does it meet your every single want and need in a home? Great location, neighbors, schools, amenities? Is a place you’ll live for years? Or are you caught up in trendiness and status-seeking. (Did I say that out loud?) Only you know the answers to these questions. If, after lots of research and soul searching, you decide to pursue that million-dollar casa, you need to figure out how to fit it into your budget and long-term financial strategy.
Here comes the math.
Math: Every dollar you earn in life will be used for one of three things – taxes, savings or life, which is everything besides taxes and savings. In our experience, you need to allocate 30% of your income to pay income and other taxes. Another 20% should go to long-term savings. That leaves 50% of your gross income to cover all your spending, including a house payment.
The housing industry says you should allocate up to 28% of your income to a house payment, including principle, interest and property taxes. At Wela, we think that number is a little high. We encourage clients who are looking to build a retirement nest egg to limit the housing spend to 20-25% of their income.
Buying a million-dollar property will likely require a 20% down payment, or $200,000. If you can pull together such a sum, you have to look at that stack of cash and think about the opportunity costs. What else could you be doing with that much money? Investing it your retirement fund? Buying a rental property that would generate income and grow in asset value?
Ok, ok! We get it. You really want that house. So, now you need to borrow $800,000.
Your interest rate on that 30-year jumbo loan will be about 4.0%, which gives you a monthly mortgage payment of $3,800. So, if you are heeding our wise advice to limit your mortgage to 20-25% of your gross income, you can theoretically afford the house with an annual income of $182,00 to $228,000. But that’s just principal and interest on the loan.
But how does this impact your taxes/savings/life model? If you make $182,000, you should have about $91,000 per year earmarked for “life” expenditures. Of that, about $45,000 --almost half--will go to the mortgage. Can you meet your remaining needs/want on $46,000 per year, a.k.a. $3,800 per month? Food, clothing, utilities, car payment, vacations, child care, golf, cable, kids birthday parties?
Probably not. You will almost certainly have to significantly reduce your 20% contribution to savings. Worse, you may be tempted to take on a credit card and other consumer debt.
So, to determine how much you need to truly afford a million dollar house, you need to calculate your non-mortgage “life” expenses to see how much more you need to meet your obligations. Remember, buying the house adds to those expenses with upkeep, decorating, yard maintenance, et cetera. While that figure will be different for everyone, it’s safe to say that you actually need more like $328,000 in annual income to truly afford that million-dollar home.
Remember all this as you try to figure out how your co-worker Justin lives in this hip, adorable neighborhood -- the one your fiancée loves. You know that dude doesn’t make much more than you. Maybe there is family money. Maybe Justin’s wife, Ashley, is a cardiologist. Or maybe Justin is up to his eyeballs in debt and hasn’t saved a dime in four years.
If that last one is true, congratulate yourself. It’s relatively easy to buy an expensive house. It’s harder to keep your financial house in order. And, as with most things in life, the harder thing is the more rewarding.