How much to spend on a house?

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).

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.

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53 thoughts on “How much to spend on a house?”

1. 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

2. 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.

3. 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

4. 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.

5. 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.

6. 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) …

7. 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

8. 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?

9. 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
– Inflation-protected securities (a.k.a. TIPS)
– etc.

Keep reading, as we will cover all of these and more in upcoming posts. AJC.

10. 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!

11. @ 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!

12. 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?

13. 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?

14. @ 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.

15. 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.

16. @ 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.

17. 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

18. @ 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!

19. Pingback: Money Hackers Carnival - #4

20. 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.

21. @ 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.

22. hej, sorry, my english is bad.
what do you mean by “borrowing against” the remaining equity to invest or “borrow against” it to invest in long-term, income-producing assets

thanks for help!

23. @ Jonathan – If your house has some equity in it (or you own it outright) you refinance and invest that borrowed money elsewhere (say, buy some stocks or buy a rental property).

24. AJC,
Has anyone noticed that 20% of \$200,000 is \$40,000, not \$50,000? That glaring mistake kind of obscures the larger point you’re making, for me anyway.

It’s an interesting concept, this 20% rule. It says, “I don’t want more than 20% of my liquidity ‘sitting around’ not earning me money.” There are two perspectives I’d like to offer on that:

1) Your equity isn’t just sitting there, it’s keeping you from paying rent. The great thing about a house is you’re using 100% of the asset and paying rent (interest) on the part you don’t own. That equity is keeping you from paying a higher “rent”.

2) The investment had better have a higher return (on an after-tax basis) than the percentage rate (cost of capital) that you’re paying to extract the equity (e.g., the HELOC interest rate). Of course, if you can afford (in terms of time) to be a landlord, the combination of tax breaks, property appreciation, and cash flow could give a reasonable rate of return to offset the cost of capital. Start your own business, hopefully one that isn’t capital intensive (like the next Facebook), has a good chance of doing the same. But just investing in the stock market seems like a losing proposition. If you’re getting a consistent return of 5% above inflation you’re doing REALLY well! And leaves you with a very small margin over your cost of capital, and it doesn’t address the higher risk involved (just look at the last 18 months).

My overall assessment is that people should identify the opportunity that will have the highest risk adjusted return, and then be willing to capitalize it from their liquid assets, leaving 20% as equity in their home. Without such an opportunity, it doesn’t make sense to pay higher rent.

Keep up the good work. Keep those ideas coming.

25. Just a quick follow-up: So your readers might be saying, “Why not take this 20% rule to the extreme and simply have 100% of my money working for me?” One thing that isn’t obvious is that the investment in your home has a good chance of increasing in value. By literally renting, you’re giving all of that appreciation in the value of the property to the landlord. Besides reducing your “rent”, 20% of your equity is also giving you entre to that appreciation.

Of course, if your house only costs 20% of your liquidity, you win both in appreciation and freed-up cash flow (not paying a mortgage). There are two ways to get there: Increase your liquid assets or reduce your lifestyle (i.e., cheaper house).

One way to live in a nice, cheap house is to avoid the city. That implies having a business/job that doesn’t depend on your geography. Imagine the possibility of making what you do now, but living anywhere!

26. @ JMeogh – Thanks for picking up the obvious typo; nope, this post is one of my oldest and most widely read, yet you’re the first 🙂

If you’re not paying rent, you’re paying a mortgage on your own home. So, I recommend that you ‘pretend’ to pay yourself a commercial rent and see if owning your own home REALLY stacks up on a risk-adjusted basis.

BTW: By all means invest > 75% of your Net Worth … the more, the better.

27. Hi,

I’ve been reading about this 20% rule and it does make sense, but after what happened with real estate over the past 18 months do you still think this is a good approach? Right now, I have about 55% equity in my home. To get my home to only be 20% of my networth I would need to refinance it to 80% LTV. I have a pretty low rate (4.625%) and only have 9 years 8 months left on my mortgage. Would you still recommend someone in my situation refinancing?

Not all of my net worth is in my home. But about 55% of it is, which is why I was curious about this 20% rule. My home use to be over 80% of my net worth, but I am a very good saver and have gotten that down to the current level in a rather short period of time. My savings rate is 50% of my gross income. I have a decent amount of disposable income after retirement investing and have been searching for what to do with it. I ran across your site and have read many of your posts and then I ran across this post on the 20% rule. I just wondered if in my situation, you felt it was a good idea to refinance a loan that only has less than 10 years on it, to a 30 year and take my equity out. I’m just not sure that I could take that equity and earn a superior return elsewhere without a lot of risk.

29. @ Lee – Another way to say the 20% Rule (actually, in conjunction with the 5% Rule, which says how much of your net worth to have tied up in other non-income producing ‘assets’ like cars, furniture, etc.) is:

“Always invest at least 75% of your Net Worth in income-producing investments.”

However, if you feel that you can simply save your way to your ultimate financial goal, then don’t let me stop you 🙂

I’m not saying that your rule of thumb about having only 20% of your net worth tied up in your home is a bad thing. And no, I don’t necessarily think that I can just save my way to my ultimate financial goals. I was just wondering in my situation would you really take equity out of a home when you owe ~9 years and refinance that to a 30 year just to get it to 20% of your net worth?

31. @ Lee – Aaah, now we’re getting somewhere 😉

It seems that your current strategy isn’t working for you … so, what do YOU think you should do about it?

It’s working, it’s just slow going compared to your strategies I suppose. I’m not under any illusion that I would not need to take more risk in order to accomplish some short term goals I have. But on the other hand, i’m not as astute a business person as yourself, which probably explains why my investments have been pretty conservative thus far. I also know that my biggest income producing asset right now is my job and I have been working hard to free up much of that income to be able to invest as much of it as possible. Of course, what you invest in, and what I do is the problem i’m sure. As I said earlier, I would love to find better ways to have better returns on my capital, but you probably know much better ways to do that than I do.

Even if I did refinance my home and take the cash out and use it to purchase let’s say some rental property, I still would not necessarily be able to make that work out any better than paying off my home and freeing up that full payment. Of course maybe I’m not giving myself the benefit of the doubt that I could do something like that. It’s just not familiar to me.

While I do not disagree with any post I’ve read on your blog in regards to building wealth and doing it more quickly (not as in get rich quick) I am a realist in the fact that most people would probably fail just because they don’t have the proper education and plan going in to make it work. I know what you accomplished sounds great to most people. After all, who wouldn’t want “7 million in 7 years”. But being realistic, what you accomplished was extremely hard work and took a great deal of intelligence and planning on your part to make it happen. A lot of people for whatever reason simply would not have the success you had.

Now that being said, I wouldn’t be here trying to gain knowledge if I didn’t think it would improve my way of thinking and possibly give me the confidence to do what may be necessary to pursue those short term goals I have.

33. @ Lee – perhaps I misunderstood, so let’s backtrack a little:

1. Do you have a Date in mind, when you REALLY want (nay, NEED) to stop working so that you finally have time to live your Life’s Purpose?

2. Do you have a Number in mind, that represents how much you need in your nest egg (be that the bank, ‘passive’ investments, your house – although, you may need to think how you plan to access those funds to live from – etc.)?