The best home buying rule I can offer you is my 30/30/3 home-buying rule. If you follow my home buying rule, you will have a greater chance of surviving any financial downturn. Even if you just follow one part of the rule, you will also be able to enjoy your property more because you will be less stressed about your finances.
Way too many homebuyers overextended themselves during the 2008-2009 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.
There is a lot of demand for real estate during the pandemic. You can get a 30-year fixed-rate mortgage for under 3%. The stock market is volatile. Finally, we’re all spending way more time at home.
It is only logical that interest in real estate has increased. However, this is all the more reason to stay disciplined.
Just look at this national home price appreciation chart during a pandemic. It is accelerating!
For those of you buying a home during a period of maximum uncertainty, please follow my 30/30/3 home-buying rule. Not only will the rule save you from a lot of stress, but it will also better protect our economy.
The 30/30/3 Home-Buying Rule
Here are the three home-buying rules to follow. The goal is to follow all three home-buying rules. If you can’t, you must follow at least one.
Rule #1: Spend no more than 30% of your gross income on a monthly mortgage payment.
Traditionally, the industry says to spend no more than 30% of your gross income on your monthly mortgage payment. However, as mortgage rates continue to decline, more people are tempted to increase the percentage.
When mortgage rates are lower, you can already buy more home if you keep your spending as a percentage of gross income fixed. The danger emerges when you break this home buying rule percentage to buy an even more expensive home.
The people most at risk of breaking the first rule of home buying are middle income to lower income people.
Spending 40% of your monthly $50,000 gross income on a mortgage still leaves you with $30,000 in gross income. However, spending 40% of your monthly $5,000 gross income leaves you with a much smaller cushion.
You must be able to take care of your basic needs with the remaining money. Therefore, it is safer to spend less of your monthly gross income on a mortgage the more income challenged you are.
Rule #2: Have at least 30% of the home value saved up in cash or semi-liquid assets.
Before buying a home, 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 get the lowest mortgage rate. The other 10% is for a healthy cash buffer just in case you run into financial trouble.
I realize that there are programs that allow you to put down a smaller down payment. However, during times of maximum uncertainty, it’s better to have a larger financial cushion.
The homeowners who got blown out the quickest during the previous recession had minimal down payments. With minimal equity, the temptation to walk away from a mortgage is much greater. The thousands who did between 2008 -2012 missed out on one of the largest real estate recoveries ever.
If you are planning on buying a home within the next six months, keep at least the 20% down payment in cash. It is unwise to invest your downpayment in stocks and other risk assets if your home buying time horizon is so short.
If you don’t have at least 30% of the value of the home saved up, it’s time to curtail your desires. Eat ramen noodles for the next six months to save money. Start a side hustle to boost your income.
Borrowing the downpayment from the Bank of Mom is pretty common nowadays. However, before you do, you need to ensure that you aren’t putting your parents at financial risk.
Rule #3: Limit the value of your target home to no more than 3X your annual household gross income.
Home affordability based on cash flow is a function of the price you pay for the home. If you are able to meet the first two home buying rules, then you can tie it all together with the final home buying rule.
Rule #3 is a quick way for homebuyers to screen for homes in an affordable price range. The rule also takes into consideration down payment percentages and prevents one from stretching too much, even with a high down payment.
If you earn $100,000 a year, you can comfortably afford up to a $300,000 home. Or maybe you are lucky enough to earn a top 1% income of $500,000 a year. If so, then you can comfortably afford up to a $1,500,000 home.
Again, with mortgage rates collapsing, housing affordability has gone up. Therefore, you could stretch the third home buying rule and extend the home value up to 5X your annual household income.
Just know that 5X a larger salary not only means more absolute debt, but also higher property taxes, maintenance expenses, and so forth. Make sure you run all the numbers before you make any home purchase.
Home Buying Examples
Two examples of following or closely following the 30/30/3 home-buying rule
You make $100,000 a year and have $120,000 in cash saved. You desire to buy a $300,000 home. After putting 20% down, you have a $240,000 mortgage. The monthly payment is $1,012 or just 12% of your monthly gross income. With a $60,000 cash buffer left, you have almost five years of mortgage expense covered.
With the same income and cash savings, you decide to live it up a little and buy a $400,000 home instead. After putting 20% down, you have a $320,000 mortgage and still have a good $40,000 cash buffer. Your monthly payment is $1,349/month at a 3% mortgage rate. The payment is still only 16% of your monthly gross income of $8,333. This is good compared to the 30% maximum recommendation.
Thanks to low mortgage rates, you can see how stretching to buy a house worth 4X or even 5X your annual income is possible. However, I do recommended sticking to a 3X multiple if you want that wonderful feeling of financial security.
If America was filled with homebuyers like this, then the 2008-2009 housing crisis would not have been nearly as bad. Unfortunately, too many homebuyers didn’t follow the 30/30/3 home-buying rule. Most of us suffered as a result due to foreclosures and short-sales that brought our property values down.
An example of someone not following the 30/30/3 home-buying rule
You make $120,000 a year and have $100,000 in cash saved at 32 years old. Not bad. However, you’re also salivating for an $850,000 home, which equates to 7X 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. However, your monthly payment of $3,543 is 35.4% of your $10,000 gross income. It’s probably closer to 40% due to PMI. You have now violated all three of my home buying rules.
If you lose your job, you will run out of cash in four months. You may get lucky holding on with enhanced government unemployment benefits and a couple stimulus checks. However, think about how stressed you will be during this time period.
Instead of buying this 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.
Further, your mortgage will decline to $680,000. At a 3.25% mortgage rate, your mortgage payment would be $2,959 or 29.6% of your monthly gross income. If your income increases while you are patiently saving for a larger downpayment, even better. Shop around for a better rate.
An example of a terrible violation of the 30/30/3 rule
Rule #3 helps prevent a homebuyer from going off the deep end. Sometimes, people confuse their own true buying power with reality. Receiving a windfall can play tricks on some people.
Let’s say you make $70,000 and have a $500,000 down payment due to an inheritance. You feel rich! As a result, you may be tempted to buy a $1 million home since you can put $500,000 down.
If you do, your $2,316 monthly mortgage payment equals 40% of your monthly gross income. But then you get furloughed shortly after purchase with no pay. Three months into furlough, your boss says they won’t ever be hiring you back. You are screwed because you have no cash buffer. You thought the $500,000 windfall would be a regular thing. But people only die once.
You end up going into foreclosure. Your credit and finances are ruined. The property values on your block all take a hit thanks to you. Your financial life is over for several years.
Or in one man’s case after foreclosing on his home, he went on to get a job at The New York Times as a finance columnist. That’s right, even after deciding not pay back his mortgage, he still got a job giving financial advice. Anything is possible folks.
Ways To Get Around The 30/30/3 Home-Buying Rule
Although the 30/30/3 home-buying rule may seem stringent in such a low interest rate environment, just know 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 home-buying rule, then at least consider the following:
- Rent out a room or a portion of your house
- Create a business on the side to have a legitimate way to deduct a home office and other expenses like internet
- Be in line for a raise or secure a new job with a raise and promotion
- Build new passive income streams to help pay for your homeownership expenses
- Be really good to your parents and rich relatives
Have Discipline When Buying A Home
I get your desire to own a nice home. I’ve been a real estate fanatic since I was in college. We want to live life to the fullest now! What’s the point in working so hard if we’re just going to hoard our cash right?
A home can be a solid investment. It not only provides shelter, but it can also be rented out. Your home could even appreciate handsomely in value over time. Due to home price appreciation, many people I know have effectively lived for free over the decades.
Further, if your kid graduates with no employment prospects after four years of college and $200,000 in tuition expense, he can live in one of your investment properties. There would be no need for your adult child to live with you. This option may be worth a lot to some investors.
Despite all these benefits of investing in real estate, just don’t overextend your finances when buying a home. The stress is not worth it.
For those of you who are looking to achieve financial independence sooner, follow the FI home buying rule. This rule recommends you keep your home expense to no more than 10% of your monthly gross income. If you follow this home-buying rule, your path to financial independence will be much swifter. You may even start feeling as light as a bird.
At the very least, please follow my 30/30/3 home-buying rule before making one of the biggest purchases of your life. It’ll be good for you in the long run. It’ll also be great for your neighbors and the entire financial system as there will be less of a chance you’ll be foreclosed.
Best of luck in your house hunt. Please stay disciplined!
Real Estate Suggestions
Explore real estate crowdsourcing opportunities. If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise. Fundrise is one of the largest real estate crowdfunding companies today. It’s free to sign up and look.
Take advantage of record-low mortgage rates. Check out Credible, my favorite mortgage marketplace where prequalified lenders compete for your business. You can get competitive, real quotes in under three minutes for free. Mortgage rates are down to all-time lows. When banks compete, you win.
Updated for 2020 and beyond.
Does 30% include property taxes + insurance or purely mortgage.
If you want to put down 40% and take home is 180-200. What is safe?
How the hell would I apply this rule in Denver, CO? Homes here average in the 500k range.
What do you mean? The household requirement would therefore be $167,000 for a $500,000 house.
Not factored in are all the costs associated – home insurance, property taxes, and how about those that inspire to get a 15 or 20 year loan. I’d rather live in a smaller house that’s paid off then get myself into big debt that’s going to take an additional 15 years to pay off. Also, living in high property tax areas can really eat into what one could be saving instead. For example, property taxes in the Austin, Texas area are 2.25% or more. That’s almost $1000 a month on a $500,000 house in taxes. Finally, with the new tax law all the tax advantages of mortgage interest are gone. If you are single or a couple look into buying a duplex or four plex.
If you follow the 30/30/3 rule, all those costs should be easily digestible. That’s the beauty of my rule.
It all depends on your situation. My mortgage is about 65% of my take home pay and my wife doesn’t make much while in grad school. My wife and I travel a lot but still save every year. We plan to remain kid-less while in this home and I can not lose my job so our situation works, and meanwhile we have gained a lot of equity in the home. You have to crunch the numbers and also understand your situation, now and future.
I hope all is well. I posted in the FS forum, yet haven’t rec’d many responses. My wife and I are in the process of potentially buying our first home. We have 2 children and are interested in a relatively affluent suburb in the Northeast where we have various family members. I simply wanted to know what you thought was a reasonable and acceptable amount to spend on a house/housing expenses. My wife and I are both in the advertising industry and make approximately $420Kish gross combined. Additionally, we have saved over $2.5M in savings, of which $2Mish is in taxable accounts. These assets are predominantly in equities.
We would expect to have relatively modest growth in our income.
We were thinking of spending around 1.75M with approx 1.2% property taxes. Additionally, we are open to an interest only mortgage option to make the payments more manageable or a 10/1 Arm. Do you think that is reasonable or too much money to spend on a house. Any feedback would be greatly appreciated! Thanks.
I feel like the fed has tricked society into the massive increase in home prices by pushing interest rates so low. If everyone would follow the rule of not financing more twice your annual income for a home purchase as suggested in the Millionaire Next Door, then housing prices would naturally stay down and be affordable for the masses. I realize the book was written in the early 90s, but even if interest rates were at 14% like they were in the 80s then you would be at 28% DTI on a 30 year note. Take your now 3% interest rate and apply the 2X rule and you are only at 10% DTI, allowing much more room for investing and growing your net worth outside of a non-income producing asset. Put it on a 15 year note like Dave Ramsey suggests and you are still only at 16% DTI. I really like the 2X rule.
Sam, longtime fan of your site. You did a post a while back on how to invest a downpayment. I was wondering if you have any additional thoughts on this topic in light of the current economic climate. I am currently sitting on a few hundred thousand in cash, which I’ve set aside for a down payment on a larger home. Am hoping to buy within the next 6-18 months. Trying to think through whether it makes sense to invest some portion of this as a hedge against inflation.
That’s why geographic arbitrage is so important. I lived in a high cost area (DC) for 5-6 years, built up experience/networking, then moved to a lower cost area (Colorado) and purchased a home before real estate got insane here. My total payment (mortage + taxes + insurance) is < 10% of my monthly gross, and I'm using this margin to pay down the loan in 5-6 years. Plan is to have the house paid off before I'm 42 (I'm 37 now). Already up 40% on the home value from the purchase price, and looking at "up and coming" areas to invest in real estate (Idaho, Utah, etc.).
We're all planners on here, so I definitely suggest either moving to a cheaper (up and coming) part of the country to live/invest if you want to maximize your ROI and retire early. I agree with Sam's "Investing in the Heartland" strategy – the coasts have become too pricey.
Aloha,
Since you write about Hawaii, what is your thought on how much you should pay?
Also, what is the dollar value of your regret of not moving to Hawaii either before ar after Covid and how much more happy are you in SF?
Cheers,
Johnny R
Hi Johnny, how much should I pay for what? Besides the 30/30/3 rule?
My plan has always been to relocate when my son turns 5 in 2022.
The only kink in the plan is that preschool is temporarily shut down.
How about you?
I like these rules. Too many people try to stretch to buy a home. When there is recession they get burned.
Aloha,
My wife and I currently live in Honolulu and own a 1 bedroom apartment with a kid on the way. We are looking to purchase a home within the next year or so, but even with the equity from our apartment it will be very difficult to follow the 30/30/3 rule. As you know homes start at 1m+ in decent areas. We make around 200k a year so a home could push us past the 5x or 6x threshold.
I realize more info is needed based on our financial situation but any advice is much appreciated.
Steve
I own 3 homes one had a 3.5% down payment, the other had 10%, and tbe other had 5%.
2 of them are multi family homes which make me $5,000 profit a month after my mortgage and taxes are paid.
My 3rd home is a single family. My mortgage is $3,000 a month.
Hence I can Still profit $2,000 a month. I basically broke the rules but I think it worked
I’m not sure I agree with the second part of this rule. I’m a little confused, especially since you live in the Bay Area so you know it’s not really feasible to follow this rule here. I live in Santa Clara, so a 1200 sq ft home here costs $1.3M, which means I better be making $400k/year to buy a small 50-year old home? That seems crazy.
Yes, $260,000 – $434,000. You can stretch to 5X after a 20%+ DP, but I wouldn’t go past that.
But in that case, the vast majority of people living here shouldn’t be buying homes. The median income in the county is $120k. Even the nicer cities in the county like Saratoga and Los Gatos, the median income is still $150k. But you’re going to be hard-pressed to find any homes below $500k. Searching on Zillow for my zip code (by no means a nice zip code) shows that the cheapest place to live for $500k, which is a 600 sq ft condo, 1bd 1ba. There are no townhomes or houses in this zip code selling for less than $1M (technically there’s some for $998k, but that’s basically $1M). Even stretching to 5x, there’s no way for the majority of people to buy their residence here, especially if you have kids and need 2 or 3 bedrooms.
I think a lot of homebuyers are dual income households. Further, many Bay area home buyers have tremendous Down payment help from their families.
What is your household income situation and what are you looking to buy?
They are, but the numbers I cited are median household income, not individual, so it accounts for that.
I’m not looking to buy for a while, I don’t have much saved up for a down payment as I just started working and may not settle in the bay (but wherever I am in ~5 years I would like to buy a house, so I need to start focusing on a down payment soon). I make decent money as I work in tech ($140k/year after bonuses and RSUs), so I’m not too worried, though of course I could get laid off and that would throw a money wrench into everything. But anyway, maybe you have some advice as to how much to start saving towards a down payment vs retirement? Assuming that I’ll need $100k-150k in cash in five years, should I just divide that by five and throw that into bonds/CDs each year? Or should I save less now and more closer to the purchase year?
Hi Sam,
No offense, but your advice specifically for HCOL areas seems often to be contradictory. On the one hand you have frequently pushed buying property in San Francisco, but as Anonymous points out (and others below) this post appears to suggest that only a small fraction of the City – perhaps less than 10% – should buy real estate. It leaves me as a reader confused.
Thanks for any clarification you can provide!
No offense taken. What is the contradiction that you are seeing?
I’m saying for a high cost of living areas, you can stretch to five times your annual household income to my house, especially with interest rates so low. But I wouldn’t recommend going over that. Because we are already violating the 3X rule.
Not everybody can buy home. Dual incomes are often needed, as well as help from parents. But those are the type of people who are buying homes in HCO living areas.
I’m sticking with 3X to no more than 5X.
I think you’ll be surprised at how many people were buying $1.5 million homes are making between $400,000 to $500,000 as a couple.
Great article, even more important to follow given the current economic environment.
Mortgage rates are rock-bottom which is appealing to the mortgage-holder – I personally refinanced at the beginning of the pandemic and was able to bring my 30yr fixed down from 4% to 3.25%.
However, low rates aside, I think it’s somewhat of a risky time to purchase a home. Many are unemployed and banks likely won’t approve mortgages without income coverage. It’s also not the best time to commit a lot of money towards a down payment – people need to beef up their emergency funds.
With that said, there are many deals to be had – lots of people may want to get out of their homes because of the pandemic (perhaps drive to the suburbs), so some will do the work to get a great deal on a house at an all-time low interest rate.
The variability and riskiness keeps me on the sidelines at the moment (I’ll rent out my current home and purchase a second in the future), but thank you Financial Samurai for some great insights!
– Journeytoretire
Hi Sam, what about using RV ratio to see if a home is a good buy or not? If it is a good tool to use won’t I be missing some good areas because they are pricey for good reason. FOr instance, Analyzing some areas like Bend, Oregon, the prices look too high but people are willing to overpay thus increasing values of the place over the long term. Applying RV ratio it’s too expensive. I know a bit more about stocks: if I analyzed PE ratio of some tech stocks like Apple, it looks expensive relative to its decent valuation a decade ago. But warren buffett seems to be willing to overpay. So exceptions apply to a few areas in the real estate market? Am I over relying on RV ratio when analyzing if a property is a good investment?
Good thoughts, Sam. I even think 30% of gross income towards your mortgage payment is a little high, although my perspective is skewed by living in an area where home prices are very affordable (partly by choice). But if your goal is to maximize saving – then 30% seems a stretch.
Sure. 30% is the max recommendation. I recommend 10% or less for all living expenses. See: Housing Expense Guideline To Help You Achieve Financial Independence
Hi Sam,
If I remember correctly, you were looking for a discount before buying. Are you still waiting or ready to pull the trigger at current pricing?
Hi Sam,
I am a fellow Bay Area resident, almost 2 years into my first job as a chemical/environmental engineer at a small consulting/design firm in Santa Clara. I’m making $70k currently and think that $100k+ in 4-6 years is a reasonable projection.
In addition to saving just under 25% of my income for retirement, I’m contributing just under 25% to a 50/50 bonds/stocks account for a down payment (the account is set up to slowly increase weight in bonds over time). I’ve been poking around on MLS sites to get a rough feel on the market. It seems like almost everything in San Jose, Milpitas and Fremont starts at $500k for 1 bed condos and 600-700 for 2 bed/2 bath condos and townhomes (SFHs and anything up the peninsula are fantasies, and anything in the Tri-Valley or further north than Fremont would make for an unappealing commute). Saving up for the 20% down payment and 10% cash buffer would easily take me 7-10 years, and I would need mortgage rates to remain near the current historic lows to meet the first part of your rule. But even then, my salary would be nowhere near enough to qualify for the 3x rule!
It is crazy how expensive real estate is in the Bay Area. Buying here on a single non-tech income seems like quite the challenge.
Hi Matt – Good job being diligent saving. Yes, if you are a single homebuyer you are at a disadvantage to the vast majority of buyers who are dual income buyers. Not only that, they have dual income + RSUs + Bank of Mom & Dad. It’s not a fair fight.
I realized this back in 2005 when all my neighbors in my old neighborhood had their parents pay their downpayments. The same thing in my current neighborhood. A Massive Generational Wealth Transfer Is Why Everything Will Be OK
For the Bay Area.. it’s really more a 5X rule.
Nothing wrong with renting!
I lucked into an extremely low rate for a room in North San Jose – minutes walk away from grocery stores/restaurants and 15 min drive or 30 min bike ride from my office. I’m holding onto this spot forever until my girlfriend and I move in together or I have to relocate for a new job!
What is your opinion on the value of 1bed/1bath condos vs 2bed/2bath? After reading around, it seems like most people point to the 2bed/2bath option – cheaper per square foot, ability to rent out the extra room if HOA allows.
2/2 will appreciate more, hold its value more, and has more flexibility imo.