Financial Samurai

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”

Alrighty, thank goodness it’s October!  After declaring September to be frugality month (“Samurai September”), I’m finally free to splurge on as much junk as I want!  Was it painful for a recovering spendaholic to not buy anything other than food for a whole month?  Damn straight it was!

Here are some things I learned along the way:

1) By writing out a promise whether it is on a piece of paper stuck to your refrigerator, or on a world-famous website, your goals become REAL.  Writing out my goals really motivates me to stick to them.  It’s just like when you have your To Do List on a notepad.  If there’s one thing that’s not crossed out, you do your darndest to execute .  Focus on the mission soldier!

2) When your goal is to not spend money, you start revisiting things you already have and enjoy them again.  I went through my 1950′s baseball card collection that I had stashed away in the closet and had a fantastic time reading all the stats of great players such as: Mickey Mantle, Sandy Koufax rookie, Roberto Clemente, Yogie Berra, and Al Kaline.  I picked up my dusty Martin acoustic guitar and learned how to play: “This Is The First Day of My Life,” by Bright Eyes, “Every Rose Has It’s Thorn” by Poison, and “Blackbird” by Paul McCartney pretty well.  Finally, my old Klein mountain bike sure got plenty of good use as well.

3) Once I got in the habit of appreciating all that I have, I started not wanting to buy new stuff.  My five year old G4 iBook is a great example of making due with less.  In fact, I wanted to start selling stuff and getting rid of clutter.  There’s no sacrifice in my mind anymore about not buying new things out of desire.  The only things I need to buy now are things out of necessity, such as replacing my loafers given they have holes in them.

4) Time really goes by quickly. I still remember very clearly when I wrote my declaration, and now it’s over.  But, what remains is a nice chunk of change in my savings account because I didn’t splurge on stuff I didn’t need.

5) It’s more fun doing things together! I joined a club of like-minded individuals who want to be millionaires eventually.  I discovered a guy who works three jobs to make ends meet (Brian at My Next Buck).  Brian then introduced me to another fella who was $101,000 into debt and decided to deliver pizza to pay it off  (follow Jeff on Twitter @DeliverAwayDebt.  Jeff is freaking hilarious, and makes me want to go work at In N’ Out Burger for kicks!).  I then was able to call into Blogtalk Radio and speak to Baker at Man vs. Debt and Jim at Bargaineering about their views on using cash and credit cards.  It’s just FUN to speak to, and trade e-mails with random folks, all with the same purpose of becoming financially independent. Read more…

When we first bought our $1,200 HDTV six years ago, we told ourselves never to go to the movies again until we watched enough DVDs to pay for the purchase.  Every time we went to the movies, we’d have to pay on average $20 for tickets.  A promise was made that only after we watched 75 DVD rentals ($1,500 bucks in movie tickets saved – $300 for Netflix fee), would we treat ourselves out to the theater. We reached our goal within two years, and in the four years afterwards we’ve only gone to three movies!

We realized that once we went through the initial 6 month waiting period for the latest movies to come out on DVD, all was fresh again.  We’re now programmed to watch movies with a 6 month lag, bringing us the same opening night excitement.  The annoyance of someone sitting right in front of you in an empty theater and jabbering away is no more!  Furthermore, a 52″ screen and six point surround sound system sure helps replicate the big screen experience!

THE DVD METHOD OF CD INVESTING Read more…

A reader writes in:  “FS, not sure if you heard the news, but Ken Lewis is stepping down as CEO of Bank of America by year end!  My colleagues and I work for a boutique bank, and were all hoping Ken would go on an acquisition binge again and take us out at a huge premium just like he did with Merrill Lynch.  What are we going to do?  A couple of us have already made plans to buy nice presents for our wives this Christmas on hopes that big Ken would show us the money!  Who do you think will be the new Ken to take us out?  Thanks, Jeff”

Slicing Response: Hey Jeff, we heard! We consider Ken Lewis to be one of America’s greatest Empire Builders of this century.  After swallowing Countrywide Financial, Ken’s decision to pay $50 billion for Merrill Lynch BEFORE the market opened when futures showed a 5% decline, rather than AFTER the market close was amazing!  What’s overpaying by at least $25 billion more among shareholders?  Ken was a great hero to thousands of Merrill employees for bailing them out.  Ken was also seen as the savior for many others in the industry who knew that so long as there was someone out there paying huge premiums, there was a chance at striking it rich. Read more…