Mortgages are one of the largest monthly expenses that most people spend money on, and involve a commitment to pay X amount of money over a long period of time, often as long as three decades.

It can be either, depending on your circumstances.

Here’s a quick reminder of the three criteria that all good debts must meet:

  1. It makes you more money than what it’s costing you to have it, and…
  2. It has high odds of turning a profit, and…
  3. It’s money that you can afford to lose.

Now we’ll take a look at a couple of examples to illustrate the difference between a mortgage that’s good debt and a mortgage that’s bad debt.

Example 1

Sara has saved up $60,000 cash and is debating whether or not she ought to avoid taking on a mortgage and just continue to rent a house, or if she ought to buy one.

She plans on living in the same home for at least 20 years — all of her family is in this town, there are lots of jobs, and she loves the area.  In other words, if she buys, she’ll be holding onto the property for the long term, which makes it very likely that her home would be worth more than what she paid for it by the time she’s ready to consider selling.

She’s currently paying $1850 per month to rent a house.  Utilities are not included.

She could buy a comparable home for $300,000.  If she puts a $60,000 down payment towards it, and gets a 30-year mortgage at 4% interest, her monthly mortgage payments will be about $1140 per month.  Additional expenses that she’ll have to take on that she didn’t have to worry about when renting include the following:

  • Property taxes
  • Maintenance and repairs

For the purposes of our example, Sara’s property taxes are expected to be $3000 per year, which averages out to $250/month.

And she’s budgeting 1.5% of her home’s value for maintenance and repairs each year, which averages out to $450 per month (i.e. [360,000 x 0.015]/12)

So now we’re looking at a total of about $1840 per month in housing expenses if she buys a house (i.e. $1140 mortgage payment + $250 property taxes + $450 maintenance and repairs = $1840).

Given this situation, the odds are good that she’s better off buying compared to renting.

Aside from the obvious break-even on monthly expenses, the really big advantage of buying is that 20 years from now, she’ll have paid off about $187,000 worth of the purchase price (with $113,000 left to pay off).

Assuming that housing prices go up at approximately the rate of inflation (see Appendix, 4% is a decent estimate for average annual inflation), her home will be worth about $657,336 at that time.  So if she sells, she’ll pocket about $544,000 before taking into account any realtor commissions or other expenses incurred when selling her home.

Whereas if she rented, she’d get nothing.

In this case, her mortgage can be considered to be good debt.  In fact, it’s a very good debt.  The risk is so low and the profit is so large compared to the zero she’d get by renting that buying a home is a no brainer for her.

Criteria 1 is met because she’s going to spend the same amount of money on housing whether she buys or rents, and she’ll end up making money if she sells 20 years from now as planned.

Criteria 2 is met because given her numbers and the fact that she plans on holding onto the property for 20 years she has high odds of making a profit compared to renting (because it’s highly unlikely that her property will be worth less than what she paid for it when she sells).

Criteria 3 is met because she can afford to lose the money.  If a freak calamity (ex. natural disaster for which insurance won’t cover her) happened that destroyed her home, she could afford to make the mortgage payments in addition to paying rent on a new place to live.  Sure, she’d have to downsize dramatically to pull this off, but she could do it.

Example 2

Jim is currently renting.  His job transfers him to a new city every 2-3 years.  He hates paying rent and is tempted to buy.  So he considers the pros and cons.

It turns out that while he can buy a place for the same monthly costs as he’s paying in rent, his odds of making a profit aren’t good enough to make him pull the trigger.

This is because he’s in a city with a volatile real estate market where prices have a history of making large swings over short periods of time.  In 2013 prices went up by 15%, in 2014 they went up by 5%, and in 2015 they fell by 20%.  Who knows what’ll happen this year and next before he’d have to sell.

In this case, buying a condo or house doesn’t meet our second criteria for good debt because the risk of losing money if he buys for such a short period of time is too high.

He opts to rent.

On the other hand, if Jim could have bought a well-maintained home and been sure that he’d hold onto it for at least 20 years, the risk of losing money on the purchase would have been next to nothing, because even in a volatile market, over a long period of time the general trend is for housing to go up at approximately the rate of inflation.  (You can read more about this in the Appendix.)

Mortgages and you

If you have a mortgage now, or are thinking of getting one in the future, be sure to run the numbers for yourself and determine whether or not a mortgage meets the criteria for good debt in your situation.

We all have a different tolerance for risk.  We all have varying incomes.  Some people can handle a loss (both financially and emotionally) from buying a home more easily than others.  Some people can mitigate any financial risks involved with buying a home (ex. over-budget repairs) by earning more money or cutting expenses.  Others can’t.

Always calculate the expected expenses and potential profit compared to renting for yourself, weigh the pros and cons of available choices, and make the best decision you can based on your individual financial situation and temperament.

Trailers and Mobile Homes

Although trailers and mobile homes can be used for housing, they’re not in the same category as a house or condominium when it comes to being an investment.

This is because unlike houses and condominiums, trailers and mobile homes tend to decrease in value with time, rather than increase.  As far as profit potential goes, it’s comparable to living in a car.

The exception is if you buy a cheap one for cash that’s already lost pretty much all of its value.  In other words, when you sell, you figure you’ll get all of your money back.  If doing so will cost you less than renting, this might be worth it if you want to live really frugally for a few years and save up some cash.

Obviously this doesn’t mean that buying a trailer or mobile home is always a bad idea.  Just as with anything else, everyone’s circumstances are different and there are always nuances to consider.

If buying one of these will save you money and it meets the three criteria for good debt compared to renting, then by all means go for it if it’s what you want to do.  But if not, it’s probably best avoided.

How to know if you can afford to buy a home

Assuming you’ve come to the conclusion that a mortgage is likely to be a good debt for you, here are some factors to consider when deciding how much to spend.

Because if you over-stretch your finances by taking on mortgage payments that are too high, you’ll struggle more than necessary to pay off your bad debts because too much money will be going towards housing.

First, throw out any notion of one-size-fits-all guidelines.  Despite claims to the contrary, there aren’t any.

For example, it’s commonly said that as long as your debt to income ratio isn’t greater than 43%, you’re doing fine.

Sure, if you’re making $150,000 a year, and are reasonably careful with your money, odds are that you can easily afford to spend $64,500 a year (about 43%) of it on a combination of mortgage payments, a car loan, and whatever else you borrowed money for, and still have enough leftover to pay for necessities like food, utility bills, healthcare, and clothing.

But that’s not the case for people making lower incomes.

Martha bought a condo in good times, and the mortgage payments are $645 a month.  Even though she’s a single mom of two kids, it was easy to afford this at the time because she had a decently paying job.

But then she got laid off during a downturn in the economy, and the only job she could find now pays a paltry $18,000 per year.

In theory, since she has no other debts, she should be just fine, right?

Because her mortgage payments (her only debt) only add up to 43% of her income (i.e. $645/mo x 12 months/$18,000 x 100 = 43%)

But Martha’s not doing fine at all.  She only has $855 per month (pre-tax) leftover to cover basic necessities like food, clothing, utilities, and medical expenses — and she’s finding it very difficult to pay for all that for her small family of three.

One-size-fits-all plans are flawed.  They fail to account for the differences in disposable income between high and low-income earners.

Other flawed rules

Another number that’s tossed around a lot is the 30% rule.

This rule originated from the 1969 Brook Amendment to the Housing and Urban Development Act of 1968, which introduced the idea that rent for public housing should be no more than 25% of the family income.  In 1981, Congress increased this figure to 30%.  Sources say these increases were put into place in the hopes that they’d allow rental property owners to better afford maintenance for their properties.

It’s dismaying that the reasoning for the 30% rule had nothing to do with how much the average homeowner could afford, yet it’s commonly used as a guideline for determining exactly that.

What craziness!

Even worse, is that this 30% standard is now commonly recommended to home buyers as a one-size-fits-all way of deciding how high of a mortgage payment they can afford.

Don’t be fooled

So the next time you come across a one-size-fits-all rule for how much to spend on mortgage payments, look at it with skepticism.  For most people, I recommend that you aim to spend LESS than these rules dictate.  Spending less will allow you more flexibility with your finances and make it easier to afford a bit of fun in your life.

As for how much less you ought to spend, there’s only one way to figure that out.  You’ve got to go back to basics.  Track your spending and income.  Find out how much of your spending is optional and how much of it is for non-negotiable necessities, including savings.  Only then will you know how much you can truly afford to spend on a mortgage (or even rent for that matter!).