The 30/30/3 Principle – Three Home Buying Rules To Follow
A reader writes in: “Hello Samurai! I like your 1/10th rule for buying automobiles and was wondering if you use some similar sort of calculation when deciding how much one should be spending when buying a home? Thnx, Brian”
Response: Hi Brian, thanks for your question. For those who are not aware, the 1/10th rule simply states one should spend no more than 1/10th your annual gross income on the purchase price of a car. Home buying is a tougher one, especially since people get so emotionally crazy and irrational when it comes to property. There are several key hurdles you need to meet before buying a home. The rules can be encapsulated in the 30/30/3 principle.
1) Cash flow. Traditionally the industry says to spend no more than 30% of your gross income on your monthly mortgage payment, but I think you can stretch it to 50% if you think you’ll be making more money in the future. Don’t bank on it though, as this downturn has shown many people, including myself.
50% of your gross income on $50,000/month is much different from 50% on $2,000/month mind you. You must be able to take care of your basic needs with the money remaining. Hence, I suggest spending LESS as a percentage of your gross income the more income challenged you are. I wouldn’t spend more than 30% of gross, if income is $10,000/month or less.
2) Down Payment. You should have at least 30% of the value of the home saved in cash. 20% is for the downpayment to avoid PMI insurance, and the other 8-10% is for a healthy cash buffer. There are some high-risk people out there who want their home so bad that they put down only 10%, and take another 10% in the form of a maxed out HELOC loan just to get in the home. If you don’t have at least 30% of the value of the home saved up, then it’s best to start eating only ramen to bolster savings!
3) Value of the home. Cash flow affordability is a function of the price you pay. If you are able to meet the first two hurdles of cash flow and down payment, then you can tie it all together with a proper multiple of your yearly gross income to see what you can afford. The MAX multiple I recommend is 5X if you meet the first two conditions, but 3X is better. In this case, the more you make, riskier it is to go to an upper limit multiple because of leverage. 5X $500,000 is much more daunting than 5X of a $50,000 salary for example. You can always refinance your home, but you can never change your initial purchase price!
Good Example: $100,000/yr income, $120,000 in cash saved, $400,000 home no problem! $320,000 mortgage after putting 20% down, and you still have a $40,000 buffer. Your monthly payment is $1,918/month PMI at 6%, and is a suitable 23% of your monthly gross income of $8,333. In case of layoff, you have 21 months of mortgage coverage with your $50,000 buffer.
Donkey Example: $120,000/yr income, $100,000 in cash saved, salivating for a $750,000 home. 10% down leaves $25,000 in cash, and a $675,000 mortgage since you’re doing another $75,000 HELOC to avoid PMI insurance. Monthly payment $4,000, or 40% of your gross income. 6 month mortgage coverage ratio before you run out of cash is not enough. Don’t do it!
I highly recommend making sure you pass the 30/30/3 principle before making the biggest purchase of your life. It’ll be good for you in the long run, and it’ll be great for neighbors and the entire financial system as there will be less of a chance you’ll foreclose. Best of luck in your house hunt!
Readers, feel free to send in more of your questions. We may not always have the most agreeable answers, but we’ll share with you what we think makes the most sense.
Regards,
Sam
Financial Samurai – “Slicing Through Money’s Mysteries”
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I find it interesting that your 30% rule is higher (now I’ve done the math) than I had already allowed myself to spend on a mortgage when the time comes – at current values and rates. Almost £200 higher in fact.
Nice to know, in a way.
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hypothetical question : if you had enough $ to purchase a home up-front, in total, and still had a decent cash buffer, would you?
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Great recommendation and a simple formula.
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Hi Canz – Tough question. Depends how much cash you have, and when you plan to retire. If you have a low paying job, but a ton of cash, I’d probably do so. But, if you have a high income and not so much cash after you pay for the house, then no.
It’s simple accounting really. I personally love to have cash earning interest and providing liquidity rather than locked in a house while working. My goal is to pay off my house when I retire.
Having a mortgage helps keep me financially disciplined. I like to match liability with an income stream.
Thnx for commenting! FS
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Lee – I think spending 30% of ur gross on funding a mortgage is fine so long as the other two rules are complied with.
Nothing is concrete since our incomes are dynamic and upward sloping for the most part. Put it another way, ff all criteria are met, I would happily lend the homebuyer money!
FS
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I think 30% is quite low, I spend more than 30% on my mortgage – I don’t feel that I am overstretched and probably see myself in a more lucrative position than most. I like the way that you have explained it and believe that in an ideal world it would be great to have the level of financial income to make that achievable but when you are young and starting out as you mentioned you hopefully will earn more as you get older so that initial overstretch can stop you growing out of your house faster. When I bought my first house I knew that the first few years would be a bit tight but now I have overpayed my mortgage and I am about to buy my first investment property so I think it is all about planning.
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admin Reply:
October 9th, 2009 at 6:58 am
Hi Clare – I think you’re right. 30% as a percentage of your gross income is quite low when one is first starting out and ramping up the income curve. People can stretch it to 50%, but only if you’re confident you’ll be gainfully employed and on a path to earning more.
A good example is someone who enters a 3 year analyst or associate program at a firm in a normal economy. At least they know they have 3 years to work, and every year they will likely make more than the last!
The 30/30/3 principle is just a good guideline I think for one to follow. At least 2 of the 3 should be met I believe.
Thanks for visiting. Hope the property market in the UK is rebounding!
FS
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Hey FS,
Great posting. In reflecting on it, I noted that you didn’t say much about the possible opportunity costs of using the 30/30 rule. Lets say for example that you took out a 20% downpayment – but put the rest of the funds into something steady with a relatively high yield, such as blue chip corporate bonds. Then you would have an additional 10%, presumably stashed in a savings or money market account.
Now, wouldn’t it make more sense instead of keeping this additional 10% in a savings account to invest in a small business or high grade stocks? Presumably if one has enough income to qualify for a mortgage, they should have enough wherewithall to successfully make their mortgage payments without needing to suffer low MMA or savings rates.
Am looking forward to your thoughts on this.
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Great guidelines. I like how you upped it to 30% downpayment instead of the 25% typically!
Gotta keep on saving now!! =)
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This is exactly what most people don’t know when they got to buy a house and why the mortgage crisis happened. Too much house, Too little down and Too little income. People are walking away from houses they can afford to pay for because they don’t have enough of their own skin in the game and the media says everyone is doing it. This is great information that every first time home buyer should know and use. Thanks
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Nice ratio, but I wondered if it would still be 30/30/3 in parts of the country where both housing costs and income levels are much lower. Median home sale prices are $120,000 in my town and median income about $44,000. Median gross rental is $659, so renting is often cheaper than buying, but the owned homes are generally way nicer.
So should I stick to the 30/30/3 formula? The numbers in your examples seem so different from my reality!
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Financial Samurai Reply:
August 29th, 2011 at 6:15 pm
Hmm, did you do the math? 30/30/3 fits perfectly for 120k house and 44k income!! 36k down, a mortgage of no more than $1,200 a month and a home no more than 132k or 3x your income.
What am I missing here that you’re missing?
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And what about if you rent and you’re trying to save up for that down payment? What’s a reasonable amount to spend as a renter?
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Financial Samurai Reply:
December 1st, 2011 at 8:20 pm
Target no more than 30% of your after tax income to rent. Remember, you will never get rich renting.
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