As mortgage rates reach all-time lows due to the pandemic, demand for real estate has increased exponentially. But that doesn’t necessarily mean you should buy a home right now.
Way too many homebuyers overextended themselves during the 2008 financial crisis. As a result, most of us paid the price. Having your neighbor conduct a short sale or foreclosure isn’t good for your wealth, even if you borrowed well within your means.
To prevent buyers from the stress of owning a house they can’t afford, I came up with the “30/30/3” home-buying rule. The rule has three parts; ideally, you want to follow all three, but if not, then at least one.
Rule No. 1: Spend no more than 30% of your gross income on a monthly mortgage
Traditionally, the industry advises that your monthly mortgage should not exceed 30% of your gross income. But as mortgage rates continue to decline, many people may be tempted to go beyond 30%.
When rates are lower, you can already spend more on a home if you keep your spending as a percentage of gross income fixed. The real danger emerges when you break this rule to buy an even more expensive home.
For example, spending 40% of your monthly $50,000 gross income on a mortgage still leaves you with $30,000 in gross income. Spending 40% of your monthly $5,000 income, however, leaves you with a much smaller cushion to take care of your basic needs.
The more income challenged you are, the safer it is to spend less.
Rule No. 2: Have 30% of the home value saved up in cash
Before buying a home, have at least 30% of the value of the home saved in cash or low-risk assets — 20% for the down payment (to get the lowest mortgage rate and avoid private mortgage insurance) and 10% as a healthy cash buffer.
This might sound like a lot, especially since there are programs that allow you to do a smaller down payment. But during times of high uncertainty, it’s better to have a larger financial cushion.
Homeowners who got blown out the quickest during the previous recession had minimal down payments, which increased the temptation to walk away from an underwater mortgage. (Those who did between 2008 and 2012 missed out on one of the largest real estate recoveries.)
If you plan on buying within the next six months, keep at least the 20% down payment in cash. It’s unwise to invest your down-payment in stocks and other risk assets if your homebuying time horizon is so short.
Rule No. 3: The price of your home should be no more than 3x your annual gross income
This is a quick way to screen for homes in an affordable price range. It also takes into consideration down payment percentages and prevents you from stretching too much, even with a high down payment.
If you earn $100,000 a year, then you can comfortably afford up to a $300,000 home. Or if you have a top 1% household income of $500,000, you can afford up to $1,500,000.
Again, with mortgage rates collapsing, housing affordability has gone up. Therefore, you could stretch this final rule and extend the home value by up to five times your annual household income.
Just keep in mind that a salary five times larger not only means more absolute debt, but also higher property taxes and maintenance expenses.
A terrible violation of the 30/30/3 rule
Let’s say you make $120,000 a year and have $100,000 in cash saved at 32 years old. Not bad. But you’re salivating for an $850,000 home, which is seven times your annual income.
You can’t put 20% down, so you only put 10% down. This leaves you with only a $15,000 cash buffer and a $765,000 mortgage. Due to a lower down payment, the best mortgage rate you can get is 3.75%. This is still low by historical standards. But your monthly payment of $3,543 is 35.4% of your $10,000 gross income.
You’ve violated all three rules.
And, if you lose your job, you’ll run out of cash in a few months. You might get by with unemployment benefits and a couple of stimulus checks, but think about all the stress you’ll have to endure.
Instead of buying a home now, first save up another $155,000 to get to $255,000 in cash and semi-liquid investments. With 30% of the home price saved, you can put down 20% and have a nice $85,000 cash cushion.
Ways to get around the 30/30/3 rule
Although my homebuying rule may seem stringent in such a low interest rate environment, just know that plenty of people pay all-cash for their homes, too. This idea of taking on lots of debt to buy property hasn’t always been the norm.
If you want to violate the 30/30/3 rule, then at least consider:
- Renting out a room or a portion of your house.
- Starting a side hustle to have a legitimate way to deduct a home office and other expenses such as Internet.
- Putting yourself in line for a raise or secure a new job with a higher salary.
- Building new passive income streams to help pay for homeownership expenses.
- Being really good to your parents and rich relatives.
Have discipline when buying a home
Despite all the benefits of investing in real estate, it’s best to avoid overextending your finances. Remember, in addition to a mortgage, you’ll also have to pay for other things like homeowner’s insurance, property taxes and maintenance fees.
Buy a home for lifestyle first. If it happens to appreciate in value, that’s wonderful. If not, then it doesn’t really matter because you spent all those years creating great memories in your home.
Sam Dogen worked in investment banking for 13 years before starting Financial Samurai, a personal finance website. He has been featured in Forbes, The Wall Street Journal, The Chicago Tribune and The L.A.Times. Sign up for his free weekly newsletter here.