In a previous post, I weighed in with my thoughts on the Rent v Buy question. The answer for most people, at some stage in their lives, is to … buy.
But, how much to spend?
Boy, this is a biggie! I mean, your house is usually your biggest personal purchase. So, here goes …
You should INVEST no more than 20% of your Net Worth into your house!
[To calculate your net worth, try this calculator at CNNMoney.com: http://cgi.money.cnn.com/tools/networth/networth.html , then come back and read on, because you need the second half of the equation ...]
The ‘20% Rule’ tells you how much of your current net assets you should INVEST, it doesn’t tell you how much house you can actually affford to buy …
… because, houses can be financed!
So, the 20% rule tells you how much deposit you can afford. And, the bank will then tell you how much you can afford to borrow (unfortunately, they won’t tell you how much you SHOULD borrow … only how much you CAN borrow).
Put your deposit + mortage together, and there’s your house!
For example, say that you have saved $200,000 and it is sitting in the bank. And, assume that you have a job, but no other income or assets. Then you can afford to put down a $50,000 deposit on your house; the bank will look at your income and tell you how much you than then afford to borrow.
Why 20%? After you ‘invest’ another 5% of your Net Worth in ’stuff’ (car/s, furniture, possessions), it means that you are never investing LESS THAN 75% of your Net Worth (that would be the $150,000 that you have left in our example) in income producing assets (like investment property).
It also tells you that you should never build up more than 20% of your Net Worth as equity in your own home without then borrowing against the remaining equity to invest.
So you should conservatively revalue your house at least every 3 - 5 years and withdraw any excess equity and add it to your investment pool!
If you can’t afford to trade up to a bigger house without breaking this rule … don’t trade up! When you get rich later, you’ll be happy you waited now.
But, if you can’t buy your FIRST (very small!) house without breaking this rule, then buy it anyway … as soon as you have enough equity, borrow against it to invest in long-term, income-producing assets, and keep rechecking this post.
Add to: | blinklist | del.cio.us | digg | yahoo! | furl | rawsugar | shadows | netvouz
These numbers seem pretty out of line. One will get a better mortgage by putting in a 20% downpayment. The rules you suggest imply that you should first save 80% of the cost of a house before buying the house with a mortgage?
Also, as you pay the mortgage down, the percent of your assets in the house doesn’t change, nor will taking out an equity loan, you are just impacting your debt, and creating more risk by pulling out that money.
JOE
Thanks for your comment, Joe. The 20% Rule only limits how much of your Net Worth you should put into your house (as deposit and/or equity); how much you should PAY for your house is determined by that amount PLUS how much additional value you can afford to finance.
Those who are financially inclined can do a net present value analysis for the Buying Vs Renting comparison. Of course the assumptions regarding inflation, income growth, rise in rentals Vs property prices would be subjective, but atleast its better than bling decision making.
But overall, a useful article.
Best
Rahul
OptionSwap
Thanks for your comment Rahul. Whether the numbers stack up or not, the fact is that for many people buying their own home is the ONLY way (not necessarily the BEST way) that they will start the get-rich process. How? By releasing the built-up equity in their house FOR FURTHER INVESTMENT.
While this might be reasonable advice for you’re amount of net worth to put up as a down payment, the biggest problem is determining what you can afford as your monthly payment! I know when I was looking to buy they qualified me for a hell of a lot more than I felt was prudent. I didn’t want to be house poor and made my own choice on what I’d allow as a monthly. However, even that got stretched and we’re just pulling ahead now after a number of years. Need to be careful on what you’re stretching to get.
Good point, Peter. I will will be doing another post on the mortgage side of buying a house later … just keep the 20% in mind as deposit and/or equity (they are NOT the same thing) …
I suggest that people learn how to live with less, because soon they’ll be forced to.
I worked as a realtor and I saw the inside of the real estate market, especially the meltdown that has been happening over the last several months. The “meltdown” is beginning to effect many other sectors of the economy, and personally I think we’re headed for a second depression. Except this one will be far worse than the first.
People have been conditioned for too long to spend, spend, spend. And now this spendthrift behavior is blowing back on millions of Americans in a very financially destructive way.
Housing is almost always the most expensive part of a person’s budget, so it makes sense to try to find ways to reduce that expense as much as possible. This is where alternative home building methods come in, like building with cordwood, cob, adobe and many others. To find out more information just do a search on those terms.
I wish you all the very best.
Sincerely,
John Ubele
http://www.patrioticactivist.com
From clicking over to the 20% Rule Post: “Why 20% - 25%? It means that you are never investing LESS THAN 75% of your Net Worth (that would be the $150,000 that you have left in our example) in income producing assets (like investment property).”
I followed everything but this part. Seems since you had $200k in the bank (cash) and only invested $50k in the house, the $150k left is not doing anything (unless somehow you mean you have bought 4 houses worth $200k apiece and put $50k in all of them and you only live in 1 of them, so the other three (using your $150k to get 25% into them) are all investments. What am I missing?
There are two parts to this:
1. I am saying that no more than $50k of that $200k should be invested in your own home (borrow the rest, IF the payments fit into strategies that I will be sharing in upcoming posts).
2. The remaining $150k could be invested in anything that suits your investment horizon, passions, and risk tolerance; for example:
- Low cost Index Funds
- Income-producing buy-and-hold- real-estate
- A business
- Inflation-protected securities (a.k.a. TIPS)
- etc.
Keep reading, as we will cover all of these and more in upcoming posts. AJC.
I like this post and its emphasis on diversifying your networth. I have been attempting to shift the percentage of my networth tied up in my home to a lower percentage. I think the more wealth you have the easier it is to bring that total percentage down (unless you have the philosophy of not wanting to carry any mortgage). It is, as you have posted otherplaces, one of the first steps toward wealth generation. I was fortunate enough to have bought in 2000 just prior to the boom; consequently even though real estate has fallen some since its high, I have been able to benefit on a nice jump in equity. I have now refinanced twice trying to reduce the percentage of networth in my home equity, and shift it toward cash generating rental property…a slow but sound process in
getting your money to work for you (rather then for the bank). I know over time this is a way (without starting a business or making a huge salary) to build up networth and ultimately freedom from being tied to a salaried position.
Since I am currently immersed in this process, it is anecdotes and timelines of others on this process that are particularly illuminating for me. I am curious on yours as well as others timeline on this process.
Thanks!
@ Tim - If you keep up the good work, I might be handing the ‘keys’ to this blog over to you soon … better yet, start your own: $20 million in 10 years
In the meantime, stick around, I might have a few more ‘tricks’ to help you accelerate your plans …
But, keep it up and post often on your progress … better yet, if you (or, any of our other readers!!) want to write a ‘guest post’ e-mail it to me (using the form on my About Page) and I might even publish it … maybe even with some of my own comments and ‘critique’ thrown in!
Hi from AJC - I just updated this article; previously I said “allow 20% - 25% for the value of your house” … assuming that the range was to account for all the other ’stuff’ that you own. I’ve now made it more explicit: 20% (max.) for your house + 5% (max.) for all the other stuff that you own = 75% (min.) of your Net Worth always in Investments! Simple, huh?
Very interesting. I am exactly in the position where you would recommend that I take out some equity (about half of it!) in order to increase my other investments.
However, if I did that, I would immediately lose probably 10% of that money in closing costs (for a refinance) or fees (for other ways of getting the money out). That can’t be good. Is there something I’m missing here?
@ Debbie - 10% sounds like a lot …an alternative approach (and, this might take some work in the current market) is to find a bank / finance company / finance broker who will allow you to effectively buy your next property ‘no money down’ i.e. using the equity in your house as a deposit …. keep in mind, buying a high-price property this way is what got us into the sub-prime mess in the first place, but (if you can find an understanding bank) with cheaper properties out there, it may become viable.
Alternatives are 2nd mortgage and Line of Credit against your current house … these will probbaly mean (a) that you carry a higher interest rate, and (b) you probably won’t be able to fix the rate or pay interest-only - even so, it only affects the smaller deposit-component of your next acquisition.
You may also choose to rent this house out and live in the newer one (if you decide not to buy a small commercial property) if that helps to get a 30-ytear fixed rate loan on the balance (ideally, interest-only) for the ‘newbie’ property.
Do your homeword and seek qualified advice, before doing anything, though! Good Luck … AJC.
Okay, thanks. But I would not take money out of one real estate investment just to put it in another one. That’s not really helping enough with the diversification to be worth the increased risk to me. I thought the idea was to invest the money in something completely different like stocks, bonds, or commodities.
@ Debbie - personal choice
IMHO - owning your own home AND owning an investment property is not the same asset class. But, stick with investments that make YOU happy. BTW: you won’t be able to apply these other strategies on any asset class other than real-estate.
Really great insight — I think this makes complete sense when one is in the “accumulating phase”. Hadn’t thought of this formula explicitly, but when I look back it seems like I was trying to follow it implicitly.
The other minor issue is that technically only the first 100k of home equity is tax deductible even though banks offer a lot bigger HELOCs all the time.
Do you think the same rule applies when someone is trying to live off their portfolio? Then there might be 2 different dimensions to consider: 1) Taxable income could be less so mortgage debt could be less valuable 2) The investor may want a lower amount of volatility and risk.
Cheers
@ Gryffindor - First let me say that I like your blog … you touch upon many of the issues that I also touch on.
Rule of Thumb: Never break this ‘rule’, even in ‘retirement’. Having 75% of your Net Worth invested is EVEN MORE IMPORTANT in retirement … it’s the INVESTMENTS that you’ll be gearing (borrowing) less, though!
Great rule of thumb - this is similar to what I was looking for in purchasing our next home.
Under a similar vein, seems average multimillionaire has only spent about 10% of their networth on their home.
@ 2Million - Thanks! But, I don’t agree with the “10% Rule” … a more comprehensive and recent study by the Spectrem Group (advisors to the Financial Planning community who survey 5,000 Ultra High Net Worth and Mega-Wealthy families each year) provided a benchmark that ‘proves’ the 20% Rule to hold true for the rich …. this [pleasantly] surprised me, so I wrote to them to check and they confirmed that it holds true RIGHT ACROSS a wide-range of wealth categories from about $1 mill to $25M+ Net Worth.
BTW: I have written a f/u post giving some practical applications in applying the 20% Rule here:
http://7million7years.com/2008/04/11/applying-the-20-rule-part-i-your-house/
AJC.