One of my earliest posts introduced the 20% Rule which is a guide to how much to spend on a house.
Naturally, it was one of my most popular posts.
The 20% Rule is simply this:
You should INVEST no more than 20% of your Net Worth into your house.
Strangely, nobody took me to task, because it doesn’t really tell you how much to spend on a house!
It merely tells you how much equity to have invested in your own home. It doesn’t tell you how much house you can actually afford to buy, because houses can be financed.
For your first home purchase, or any new home purchase, the 20% Rule effectively tells you how much deposit you can afford, because (at purchase, and subject to closing costs) your deposit generally represents your equity in the property.
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!
Michael Masterson, in his new book [AJC: the first 41 pages are excellent] makes it a rule to never spend more than 25% of his net (i.e. after tax) income on housing.
I agree … this is less than the 30% – 35% ‘rule’ that the banks normally apply (although, sometimes that will only allow 35% of your pre-tax income).
For your first home, the chances are that you will need to break the 20% Equity Rule and probably also the 2% Income rule … and, that’s OK.
I want you to buy your first home … it gets you onto a ‘wealth train’ that I want you to board.
When these rules – together – are helpful is:
1. When you are sitting on too much house: the 20% Equity Rule will ‘force’ you to pull out some of that equity and put it into another form of investment (maybe stocks, maybe another rental property, etc.) or
2. When you want to upgrade to too much house: You’ve outgrown your current home and want to buy a bigger one. Now that you are on the train, there is not so much ‘wealth creation’ pressure on you to buy a bigger/better house, only lifestyle (or spouse-style) pressure to upgrade.
So the combination of these two rules will tell you what you can afford:
1. The 20% Equity Rule will tell you the maximum deposit that you can put into the new home (i.e. up to 20% of your Net Worth … most of which is probably represented by the equity in your current house, anyway), and
2. The 25% Income Rule will tell you what mortgage payments you can afford to make (I am suggesting 30 year fixed interest) … use a simple online mortgage calculator (you may need to run a few trial-and-error iterations, as most aren’t designed to run ‘backwards’) to see what is the maximum size mortgage you can ‘afford’ where the monthly payments total no more than 25% of your annual net (after tax) income.
By the way, since keeping your old house and using its equity to help finance the new house (if you can find a bank to come to the party – which may be difficult for the next couple of years) doesn’t change your Net Worth, why don’t you try and keep your old house as a rental?