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 afford 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 + mortgage 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 $40,000 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.