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!

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Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    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.

  2. says

    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

  3. says

    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

  4. clare says

    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.

    • says

      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

  5. says

    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.

  6. says

    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

  7. J. Schult says

    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!

    • says

      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?

  8. Mags says

    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?

  9. Ryan says

    Here is my scenario: I currently rent and pay 700 a month. The houses I’m looking into are in the 150,000 range. My payment with all the taxes and principle will fall in the $1100 a month range.

    Combined my wife and I make about $70,000. We are thinking about doing an FHA loan with the 3.5% down and will have $10,000 in cash reserves. With the payment only being 300-400 more than what we pay in rent, is it still a bad idea?

    • says

      I think it’s a bad idea. Your margin of safety is a 3.5% downpayment and $10,000 in cash reserves. A 5% decline in your house wipes you out.

      Shoot to build 30% of the downpayment, and put 20% down and keep 10% of the house value in reserves.

  10. Anonymous Guest says

    Hi.
    My annual net income is a little under 14,000 dollars, and I pay 7,200 dollars annually in rent. Any lower of a rent payment where I live would be putting myself in the hands of dishonest landlords, in unsafe areas, and living in unsafe and unhealthy living conditions. I am able to pay a little over 50 percent of my income in rent without a problem but, after food, work expenses, vehicle expenses, et cetera, there is literally no extra money at the end of the year. So I live okay by my standards, just with no extra money for, say, health insurance. With my current rent and the other costs of living, I will effectively be able to afford a 20 percent down payment on a house which costs three times my annual income in roughly 17 years, assuming I have saved 500 dollars by the end of each year. What are your recommendations?

    • mysticaltyger says

      You need to both earn more money (2nd job, better job, side business, or a combination of all the above) and rent a room in someone’s house to save on rent.

  11. Tyrone Biggums says

    I find it interesting that your car-buying guideline (1/10 factor) is much more conservative than your home-buying guidelines. Your 30/30/3 home plan actually seems a little aggressive in terms of how much of your income is going towards the home.

  12. Brian says

    Question: I bought a duplex last year for $250,000 and financed with FHA 30 yr fixed at 3.2% plus PMI. I renovated one side which I rent out and I live in the non-renovated side (has great yellow counters and vinyl flooring from 1977). I am 27 and this is my first home.

    I am wondering if I should try to refi out of the FHA loan and into something else without PMI. I put about $18K into the house after I closed and I have about $40K in savings that could go towards new loan and additional equity (I did the low down payment FHA because I wouldn’t have had enough money to renovate immediately after closing otherwise).

    My long term plan is to renovate my side of the duplex and then eventually buy a single family home for me to move into and start renting both sides of duplex.

    Appreciate the advice!

  13. Michael says

    Hey Financial Samurai, first time I’ve heard of this principal – EXCELLENT tips! Mind if I share them with my mailing list? I’ll make sure to include a link to this page!

    Regards!

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