A question that often comes in financial forums is the following: Most affordability numbers are based on annual income, e.g. affordability for a house or car. What happens if one has a large amount of assets, through a windfall or inheritance, but very little income?
Let's take a hypothetical example. Someone is looking to buy a house that costs $200,000. They have $500,000 in assets, but only make $50,000/year. Can they afford the house? On the one hand, they have cash to pay for it outright. But then what about maintenance costs, property taxes, and insurance? On the other hand, the income is too low by conservative standards because house price divided by the annual income is 4, which is much higher than the recommended 2.5 to 3 times.
A crude way to determine affordability is to look at the assets and see what kind of income it is capable of generating. This part can be tricky depending on what type of investments one is considering. As an example, one can use the rate of a 30 year treasury bond to determine how much income can be safely generated. If we use 3% for that number, then $500,000 is expected to generate about $15,000 per year. Add that to the original income and we get $65,000. Now the price to income ratio is about 200,000/65,000 ~ 3.0. This makes the house appear a lot more affordable. On the other hand, if we use the current rate for a savings account which is about 1%, the investment would generate only $5,000 in income annually and would increase the original income amount to 55,000. 200,000/55,000 ~ 3.6 which is still a little high.
If one decides to purchase, whether one choose to finance the purchase or pay cash is a different matter than affordability.
Another related discussion that came up was the following. If one has a portfolio of a certain size, then given that portfolio value fluctuates by 1% on a daily basis, does it mean that 1% of the portfolio is not a lot of money for that person? Taking an example similar to the above one, if one has $500,000 invested and the portfolio fluctuates by $5000 routinely, does it mean that they person can spend $5,000 without thinking twice about affordability?
The best objective answer that I saw to that question was that daily fluctuations in portfolio should be 100 times larger than sustainable average daily spending. In this case, that translates to an average daily spend of $50. This would include meals and all regular daily spending. Big ticket expenses are fine as long as they are occasional.
Let's take a hypothetical example. Someone is looking to buy a house that costs $200,000. They have $500,000 in assets, but only make $50,000/year. Can they afford the house? On the one hand, they have cash to pay for it outright. But then what about maintenance costs, property taxes, and insurance? On the other hand, the income is too low by conservative standards because house price divided by the annual income is 4, which is much higher than the recommended 2.5 to 3 times.
A crude way to determine affordability is to look at the assets and see what kind of income it is capable of generating. This part can be tricky depending on what type of investments one is considering. As an example, one can use the rate of a 30 year treasury bond to determine how much income can be safely generated. If we use 3% for that number, then $500,000 is expected to generate about $15,000 per year. Add that to the original income and we get $65,000. Now the price to income ratio is about 200,000/65,000 ~ 3.0. This makes the house appear a lot more affordable. On the other hand, if we use the current rate for a savings account which is about 1%, the investment would generate only $5,000 in income annually and would increase the original income amount to 55,000. 200,000/55,000 ~ 3.6 which is still a little high.
If one decides to purchase, whether one choose to finance the purchase or pay cash is a different matter than affordability.
Another related discussion that came up was the following. If one has a portfolio of a certain size, then given that portfolio value fluctuates by 1% on a daily basis, does it mean that 1% of the portfolio is not a lot of money for that person? Taking an example similar to the above one, if one has $500,000 invested and the portfolio fluctuates by $5000 routinely, does it mean that they person can spend $5,000 without thinking twice about affordability?
The best objective answer that I saw to that question was that daily fluctuations in portfolio should be 100 times larger than sustainable average daily spending. In this case, that translates to an average daily spend of $50. This would include meals and all regular daily spending. Big ticket expenses are fine as long as they are occasional.
Some of the terms are begging to be quantified. 'Affordability' is a rather subjective concept, like asserting that someone is wealthy/rich or 'has a lot of money'. It depends on who you ask. So it's a matter of opinion.
ReplyDeleteI think too much is demanded of these rules of thumb for them to be of much help. They'll work in some situations due solely to their imprecision or by tweaking the numbers by the abitrary interpretation of the result (should one use the "conservative standards" when evaluating the house price divided by income formula? or some other standard? the difference between 2.5 and 3 times income is sizable and could be important).
Underwriters and retail mortgage banks may use metrics and 'rules of thumb' to decide the viability of a loan but too many mortgagees get into trouble a few years into the loan term. If I was buying a house today that was on the cusp of what I feel I could afford, I would want to enlist hard numbers wherever I could. Draw up a 15 or 30 year budget that details expenses for maintenance and appliance replacement costs, insurance etc. not just daily expenses.
Of course, those with high incomes and low fixed costs may not require the same level of detail unless they're buying a building in Pacific Heights (SF) or commercial property.
It's a good thing my house is paid for... according to the affordability rule of thumb outlined in the blog post, I could never afford to buy it -- price divided by my income is close to 8!
Thanks for posting something I was able to comment on!