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 🙂