The word “afford” is one that gets tossed around a lot – especially among those considering a large purchase.
I wonder, though: How many of us have stopped to think about what the word afford actually means?
The dictionary defines it this way:
af·ford əˈfôrd/ verb
- have enough money to pay for. “the best that I could afford was a first-floor room”
- pay for, bear the expense of, have the money for, spare the price of. “I can’t afford a new car”
- have (a certain amount of something, especially money or time) available or to spare. “it was taking up more time than he could afford”
- be able to do something without risk of adverse consequences. “kings could afford to be wrathful”
- provide or supply (an opportunity or facility). “the rooftop terrace affords beautiful views”
Bankers have differing ways to determine the definition; however, the most commonly-accepted way is through the debt-to-income ratio. That is how much of your gross income is (or will be) used to service your debts. Generally speaking, banks look for a maximum DTI between 40 percent and 45 percent.
Depending on how much the purchaser wants the item, he or she may determine just how many meals get replaced with ramen noodles each week and for what period of time.
As you can see, afford is a word whose definition can be quite subjective.
But, wait! Banks use a ratio, and by definition, mathematical ratios are OBJECTIVE. Right?
Well, yes. And, no.
Yes. The mathematics behind the ratio are completely objective.
No. The motivation behind the ratio is rather subjective.
You’ll notice, I said bankers use gross income for the calculation. Just to clarify, Gross Income is the amount you see on your annual review form from HR – it’s the number you get when you multiply your hourly pay rate by the theoretical number of hours you work each year. It’s the number you discuss when you’re hiring in for a new job.
As in, [Future Boss] Congratulations, Ashley! We loved your interviews and we would like to offer you the job at a salary $40,000 per year.
And, as those of us who have been working at least a year or two know – the only time you’re likely to see that number is on your annual HR form. Since we know you are regularly contributing to your employer-sponsored 401(k) [You are aren’t you?], the income amount on your W-2 at the end of the year will be lower – and you will not have access to any of that money without significant penalties.
Gross income also doesn’t take taxes into account – and you’ve gotta pay those.
Measuring your DTI based on your gross income does no favors to your monthly cash flow.
So, why do banks do it?
Simple, banks use your gross income as the basis for your DTI so they can make more loans. And making loans is how banks make money. So, instead of looking out for you – like many of us have at one time assumed – banks are only looking out for themselves.
Don’t believe me? Let’s look at the math – Objectively.
Let’s assume a maximum DTI of 40% of your Gross Annual Income of $40,000.
|401(k) Contribution – 5%||– 2,000|
|Income Taxes – 25%||– 9,500|
After your 401(k) contribution and taxes, your $40,000 annual income drops by 28% to $28,500! That means, if you pushed your debt payments up to your bank’s maximum of 40% of your gross – or $16,000 per year – your debt would be 57% of your Net Income.
Mind you, for many people, deductions like insurance and benefits come out of that Net Income further reducing your take-home pay. So, in reality, you could see your debts taking up more than 60% of your take-home – that is, if you trust your bank. (Hint: Don’t trust your bank to look out for your best interests. That’s your job.)
So, before you ask your banker if he or she thinks you can “afford” that new car (or, worse yet, ask the F&I guy at the dealership), you first need to know what your definition of afford is.
Based on my experience, if you have to ask, the answer is “No. You can’t afford it.”
Start by understanding your finances. We can help.