I call this the How To Go Broke By Having Too Much House Rule … used (in good times) by banks and (in ANY times) by real-estate agents to keep as much of YOUR money in THEIR pockets as possible.
Under this ‘rule’ the bank becomes the ‘senior partner’ in your life: it’s usually Uncle Sam and your spouse who fight over that particular position 😉
So, how much house CAN you afford?
Well, to get started, you may have no choice but to follow our friendly Realtor, Joe del Graza’s ‘rule’ …
… you simply may have little personal net worth and not much income, and as I said in this early post, owning your own home (for some) may be the only way you will ever get ahead financially.
But, if you already own a house and are wondering if you can really afford to keep it – or even upgrade (why not, bigger houses are relatively cheaper in the current market?), then how do you decide how much house you can afford?
Simple: apply two ‘rules’:
1. The 20% Equity Rule, together with
2. The 25% Income Rule.
The 20% (Equity) Rule
This says that for a family earning $100,000 a year, with a total net worth of $100,000 that you can have up to 20% of your Net Worth tied up in the house. With a total Net Worth of only $100k that’s $20,000 … this probably won’t touch the sides of the deposit that you have on your current house, let alone moving into a bigger one?!
The 25% (Income) Rule
There’s some debate as to whether this should be based on your gross or net income … in other words is tax just another household expense or is it something that you just ignore and go straight to your ‘after tax number? Well, we’ll deal with that issue in another post … here, we will work off net (i.e. after-tax) income.
This says that you take home roughly $70k a year ($100k less 30% taxes) of which you can spend 25% – or one quarter – on mortgage payments: $17,500 a year.
A bit of trial and error with an online mortgage calculator shows that $17,500 a year (or $1,458 / month) “buys” you $250,000 of mortgage.
Add your 20% (Equity) Rule sum of $20,000 and you can ‘afford’ $270,000 of ‘house’ (ignoring closing costs).
That leads to some obvious issues in practice:
1. Usually one rule or the other will limit how much house you can afford; in this case it’s the equity rule: you will simply not have enough deposit unless you buy ‘no money down’ which is impossible in the current market and inadviseable in most markets.
2. So, for your first home, ignore the 20% (Equity) Rule first, then compromise on the 25% (Income) Rule – if you HAVE to – to get yourself into your first house … but, use these ‘rules’ together to govern any future upgrades, renovations, etc.
3. It’s easy to see why you MUST fix your mortgage rate – preferably for 30 years: your salary is unlikely to double even if variable mortgage rates double.
Remember: your house is usually your biggest expense / liability … the 7 million 7 years blog is here to tell you how to use that to help make you rich 🙂
If meeting that number: 25% of your net, means refinancing to a new 30 year loan [on existing home] with a lower interest rate, does it make sense to do it? For example, I currently have 23 years left on my mortgage @ 5.75% but if I refi to the aforementioned 30 year loan it would fit the 25% income net income rule. Accordingly, should I be more concerned about my monthly payment [25% income rule] or total cost of the loan for the house [net worth].
In addition, when you say net income are you incorporating any and all income from investments etc., not just salary from your current employer, am I wrong in this assumption?
As far as me having the 20% of my net worth on my primary, I’m spot on.
You might have mentioned this on a previous post, but does the 25% rule include or exclude taxes and insurance. As for my personal situation, If I exclude my taxes and insurance I am within the parameters, but including said expenses my payment is off around two hundred dollars. Hence my original post to refi.
@ RDiN – all good questions; they’re just “rules of thumb” 🙂
But, cost of ownership includes all costs (e.g property taxes, home insurance, but not contents insurance, etc.) that you would have on THAT property. This means that you are “off” a litle …
If you can refi. to ‘fit’ within the two rules, more power to you … that’s EXACTLY what you should do (taking refi. costs into account).
If you are asking which ‘rule’ is more important to fit into, that’s a GREAT question … for a f/u post 🙂
Perfect time for this post. Because I was wondering about the mortgage I could truly afford. I figured with the rules above, and it comes out pretty close to my assumption.
And its nice to know, because it is rather affordable in my area right now. Thanks 🙂
Where was this post when I put in an offer on a new house last month. 🙂
My current home mortgage follows the 25% payment rule…I’m at 18% of gross but it will be filled with tenants and positive cash flow by March 1st, so it’s now an investment in my eyes. 🙂
However I’m breaking the Equity vs. Net Worth rule on this home. I’m probably close to 50% on this one.
My future home, assuming the deal doesn’t fall through and I close this month, will be in the ball park of 30%.
I’m sure I’ll breaking the Equity vs Net Worth rule again here. The home is a foreclosure, so I’m walking in the door with equity which is great, but it will break the 20% rule. I’m projecting an
Rules are meant to be broken right?
I’m guessing I will have to consider some cash out refi’s in my future.
My biggest concern with a refi to reduce equity is the subsequent monthly payment that will result. While I understand the reasoning of maximizing leverage and putting the money to work elsewhere, I’m having difficulty justifying the resultant increases in monthly mortgage amounts from an affordability perspective.
What’s the point of pulling equity out to get below the 20% rule if you can’t afford to control the mortgage?
@ Jeff – Firstly, these rules only apply to a home that you intend to live in for some time … from what I understand, you are looking for a ‘speculative gain’ in the foreclosure and are looking to rent your current?
If so, they MAY be considered ‘businesses’ (a.k.a. investments … although, I tend to use this term for more passive buy/hold activities). However, this doesn’t let you ‘off the hook’ if do intend to live in one of them for an extended period (rather than ‘flip’ it).
25% of after tax income is a reasonable MAXIMUM … so, I would encourage reducing equity from, say, 30% to 20% (or less) IF you can stay within this spending limit. Again, this presumes that you will INVEST the balance of your Net Worth wisely.
We will no doubt discuss at length over at http://7m7y.com 🙂
I don’t know that I’ll ever return to the house I’m turning into a rental. That will be up to the Navy to decide. My initial plan with the home is to let the tenants help me keep it floating for the next 2-3 years to see where the market goes.
The three year point will be a critical decision for me as that is the last point where I’ll be able to sell it and keep profits tax free. In the US, if you’ve live in a residence 2 of the last 5 years, you can take profits from appreciation with out capital gains taxes. That is unless we change the rules after Jan 20.
If the market has recovered, I may sell at that point, otherwise I may keep it and rent it longer (as I said, it’s + cash flow) or I may sell and roll the gains into other properties via a 1031 exchange which allows you to defer the taxes until later in life. Decisions, decisions. At least I have options.
You’re right about my tactic with the new house. My time horizon is currently only three years in it. At that point I’m hoping that market recovery appreciation plus the discount I received by buying a foreclosure will yield a speculative gain.
My impression from your comments is that you feel I shouldn’t worry too much about either rule with either house over the short term. Although I will probably keep an eye on the equity in the rental house. I have enough gravy there with rent to pull out 75K or so and stay positive to break even on the cash flow.
Thanks for the discussion,
@ Jeff – Pretty much; I have a friend who is a realtor who annually shifts houses … he builds a huge house, lives in it for a year in order to wash off any Capital Gains Tax liability (this is NOT in the USA, by the way … so, don’t try this at home, folks) then sells it and repeats. He makes money at this; his ‘cost’ is the expense and hassle of moving all the time.
Under these circumstances, you can break the rules: it’s a business, not a home … just be careful that you don’t accidentally cross that line and end up with a home that stops being an active investment and does break the rules; it’s a sure way to end up with too much house and too little investment.
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@Jeff – I’m in the same boat but not looking for foreclosures, short sale or REO properties. Let’s discuss more on our up coming posts.
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