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!
Real estate has outperformed stocks for the past 20 years
Related post: The Real Estate Investing Rule To Follow: Buy Utility, Rent Luxury
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In your chart, you wrote that real estate outperformed stocks. Just looking at two charts (I do not have data to calculate volatility), it seems that REITs is at least twice more volatile than SPDR. So your conclusion can be reversed on a risk-adjusted basis. Any portfolio allocation based on the risk parity logic would put less into REITs to equalize daily/monthly volatility. My point is that looking just on absolute returns is often meaningless for anyone with background in derivatives. The risk-adjusted returns matter.
So let’s run some numbers. If you’re grossing $1m/year and want to spend 30% of your gross income on your mortgage, that leaves you with a $25k budget. With a down-payment of 20%, an interest rate of 3.92 and a 30-year term, that’s a ~$6.6m house, or about double your recommendation of 3X gross income. Is the idea that you should get a 10-15 year mortgage term, bringing down the price of the home relative to the monthly payment?
It’s a good idea to have at least 10% down payment. You are saying 30%, which is the best. However, most people I know are doing 3.5% (not saying they are right or wrong). Im trying to figure out what is best for me. If I have a 3.5 down payment on a 300k home and with insurance and the loan payment lets say 1,200 a month. I already pay 1,600 for rent. I know that with 3.5 I will be paying more in the long run. When considering I’m losing 1,600 a month in rent currently, doesn’t 1,200 seem like a deal? I make 110k a year and I am still able to save money after the month. So my overall expenses do not overcome my income. With this scenario, do you think it is still ill advised to do a 3.5% down payment? Thanks! Keep up the good work!
That is not possible. I have a $275K home, with a 3.4 interest rate, and put 3,5% down, and my mortgage including taxes, PMI, and HOA is about $1800. The mortgage and interest alone is $1240, but you have to count everything else that has to be paid that you don’t pay when you rent (taxes, hoa, PMI).
I think you are good to go. If you plan on staying in the home long term, try to do 5% down conventional so you don’t pay PMI for the rest of your mortgage life (with an FHA loan). After 7-8 years, the PMI can be knocked off the loan if you have over 20% equity (which you should unless the market crashes).
Is the 30% of gross income rule inclusive of taxes, insurance, hoa or is it just the mortgage payment itself?
Best to include all expenses.
Is this 30% rule in reference to first time buyers as well? I know no one that has done this for their first place. Even for a modest 300K place in average cost of living cities (ignore Nebraska for the sake of this argument) we are talking about 90K?? That would take the better part of a decade for some people. One would be later 30’s knocking on 40 in some cases before a first property purchase? Seems a little over the top. Not to mention the other road blocks in this time period taking away from savings such as the ability for a woman to have a child. I guess it could be done quick but I feel like you would need a super high income > 150k and pretty low cost of living area to amass this type of downpayment.
Yes, the 30% rule is especially pertinent for first time buyers who were the ones who got OBLITERATED during the 2008-2009 financial crisis. If they had a 10% buffer and put down 20%, there wouldn’t be so much loss.
There was once a time most people paid 100% cash for their homes.
Related: Buy Real Estate As Young As You Possibly Can
To piggyback off Sam’s thoughts (above), what about the “Kiddie Condo” loan program for kids going off to college? It seems like it would accomplish several things:
Pros:
1) Build equity versus simply allocating college funds to room & board.
2) Gets kid involved in home ownership at the youngest age possible (big deal if going to med school) or becomes rental property for kid or parents after graduation.
3) Superior living conditions compared to living on campus and allows a roommate to share in the cost of the investment versus both paying room & board to the school.
Cons:
1) PMI
2) Cost of condo (mortgage) in coastal city like San Diego (UCSD).
3) Kid is in tittle so probably reduces tax benefits for parent as rental property.
4) Could be tricky for parent to take over ownership (if that is the plan) after child graduates.
FHA Kiddie Condo:
FHA “Kiddie Condo” loans. If you want your student to be in title to the property and you want to pay the minimum amount down, using FHA financing is the easiest way to purchase a property. The FHA “Kiddie Condo” loan program helps students qualify for loans by allowing them to co-borrow with a blood relative. Down payments for this type of loan can be as little as 3 percent of the total purchase price, and interest rates are lower than those on investment properties. Maximum FHA loan limits vary by location so check to see what they are for your county.
Kid is thinking about UCSD and a 300-400K condo in La Jolla (with 3% down) would seem like a good long term investment versus investing 60K on room and board over 4 years.
I find this article a bit conservative relative to your other posts. You generally are focused on cash-on-cash return. If you can buy for 5% down and convert the property into a rental after residing in it for 1 year – isn’t the cash-on-cash return over 3.5x greater than if you put down 20% (even after PMI) ? I did exactly this and am earning ~$650/month cash in Atlanta on a $12k down payment. This doesn’t even take into account the mortgage interest deduction or the equity built.
Sam:
Thanks for your website. I have been a reader for many years now. I would much appreciate your suggestions regarding my predicament, which is the following:
I have decided to upgrade to a $532,000 home currently under contract and to be purchased soon.
I own my current home outright. It has not hit the market for resale (it will soon once my option period on the $532K home lapses and am committed to purchase it)
My listing agent will list my home for $360K going for a target sale price of $350K. My expectation is that this will allow me to net (on the low end) around $310K on the house (which will be tax free since it has been my primary residence for more than 2 years).
Since the purchase of the $532K home is not contingent on the sale of my current home, I initially contemplated drawing on a saving account with a current balance of $200K (which is my dry powder account for stock investing deployment) and divesting around $130K of Apple Stock (realizing a long term capital gain at 10%)—all to be applied as a down payment—which would leave me roughly with a $200K mortgage. Upon the sale of my $310K home, I would replenish my savings account and possibly repurchase apple stock or some other security.
Over the last couple of days, I have been contemplating levering the property to highest possible extent and putting the proceeds from the sale of my house into the market by topping my dry powder account. My strategy would be to deploy all money quickly into a bucket of monthly divided paying ETFs that would yield me around 5-7%. My plan would be to reinvest the monthly dividends and compound the returns.
I have been offered a loan product by a internationally recognized bank under the following terms.
Purchase Price: $ 532,000
Down Payment: $26,600 (yes, only 5% down)
Total Loan: $505,400
Annual Rate: 3%
PMI: Waived
Term: 30 years
Terms: 7 year ARM at 3.0% adjustable thereafter at LIBOR plus 2.2 but not to exceed 2% points ion year 8 and thereafter until a full upward adjustment cap of 5%.
I have plenty of reserves in liquid assets mainly deployed in the stock market (in excess of $1.3M)
I have always hated debt and don’t believe in high leverage but feel comfortable (recognizing there is no assurance) that I can get a better return on my money by controlling it than the 3% cost of capital savings I will get by putting a big down payment. Especially with these loan terms.
What would you do?
I would enjoy your new house and build up your savings warchest. We are at the top of the market.
Sam: Apologies if am capturing your response. Would you take the 7 year ARM and highly leverage the house or put down a big down payment
I like this rule for high income people, 2nd or 3rd time buyers, ect. For first time buyers i suggest a different rule. I call it: Don’t Buy a House.
Seriously, just live in a cheap apartment. Buy a multifamily home, 2 to 4 units, and rent the rest. Your net housing expense goes way down. Address any issues with the properties condition and begin saving for another property. Buy that nice single family house after your rental property is fixed up and performing well. You may find yourself paying little or nothing at all for your house and building equity on two properties at once. Owner occupied loans are much easier to get than investor loans, so the best time to get your real estate investments going is that first home purchase. I don’t think the Samurai would disagree with buying a 4 unit home that cash flows positive even if you can only put 3.5% down on an FHA loan.
I suspect for many reading this, the 30% down seems impossible. Would a 15/15/2 rule apply for those of us who have well above average (and “reliable”) HH incomes, modest passive income, zero debt, and savings rates in excess of 40%? And who live in rapidly growing housing markets (i.e. Portland) where rents are perhaps only 10-15% less than what a mortgage payment would be? Specifically:
Spending 15% of gross income
A downpayment of 15% (say 10% in downpayment, 5% in liquid reserves)
A home value of no more than 2x income
While I’m mentally ready to buy a home, I want to make a financially wise decision rather than an emotional one. That being said, I wonder if buying using a 15/15/2 rule would put me in a better financial position in the long-run due to rapidly climbing home prices and low interest rates, as opposed to waiting perhaps 18-24+ months to achieve the 30/30/3 rule. I appreciate your thoughts!
You must be talking about 2nd or 3rd time home buyers because who the hell has 30% of the price of the house just laying aound?
I do not think this is good advice at all. Following this rule, an average person will not be able to buy a home until they are in their mid thirties, having wasted tens of thousands on rent. Spending money on PMI or an FHA loan is far more beneficial because you are exposing yourself to leveraged appreciation. Also, you say that if you have 3.5% down and your house goes down 5% you are ‘wiped out’. What do you mean by this? You won’t be foreclosed simply for being in negative equity by 1.5%, so long as you are paying the mortgage.
In order to build wealth you need to assess the risk and rewards. Being knowledgable about where you are buying and the state of the economy is much more important than applying a strict rule. After all, you have to speculate to accumulate..
Need your help, Sam:if a bank offered you a 30-year mortgage at 3% down with NO PMI, would you take it, or would you go ahead and put the 20% (or something in excess of 3%) down? I have (a) 30% of the purchase price saved, just as you suggest, though that presently represents nearly the entirety of my cash/liquid savings and (b) the discipline to keep invested any capital I don’t put toward the down payment. In the interest of full disclosure, I should also note that (a) if I had to put down the full 20%, I’d think very hard about whether to buy as the 10% I’d have left over after the down payment is about half as much cash savings as I’m comfortable having at any given time and (b) putting only 3% down will create a monthly mortgage payment about 7-10% higher than I desire, though I definitely can afford it as it’s roughly equal to what I pay in rent currently. Been renting for the last 5 years. Any insights you have on this major life decision would be very much appreciated!!!
Not sure I can follow the logic here.
Imagine you have two people.
Both are living in relatively high cost areas. They rent homes at $2,300 per month. They each have, say, an additional $1,000 to either buy a home or save for a down payment.
Person A follows your advice and begins to save his 30%. Given that home prices in his area average, say, 500k, he would need to save 150k per your recommendations. A feat that will take a decade. But even in a decade, he won’t have enough as the homes will cost more. This isn’t even getting into the fact that his rent will likely increase.
Person B, a donkey, buys a 500k home with a small down payment (even FHA with PMI and everything) bringing his total home expenses to, let’s say $3,300.
Now, let’s look at where these two are in 5 years.
Person A has paid $138,000 to his landlord, who is very grateful. He has also saved up about 60k. He is also likely paying a good bit more in taxes without the write off.
The “donkey” on the other hand, has built up, with a 3% appreciation, and some mortgage amortization, 150k in equity. Not to mention the tax advantages, etc.
Tell me what I’m missing here?
Exactly!!! Saving 30% ($120K) could take me 8-10 years. Meanwhile I would be paying $1800-2000 in rent a month which I will never see again in my lifetime. I think it is better to buy a home than to rent even if you have 5% downpayment, as long as you buy something you can afford comfortably, and have saved up an emergency fund.
My wife and I bought our house about a year and a half ago for $136k (yah for the midwest!) and we both make around $140k a year combined. We looked at houses between $118k and $260k even though the 3X income rule says we could afford a $420k. When we took into account property tax – high in our area at about 2.8% – and maintenance, heating and cooling costs and repair costs it became evident that we wanted to be under $200k and more likely between $130k and $160k. Going in at the low end allowed us to put 20% down (though without any buffer) and we took advantage of low interest rates on a 15 year mortgage. We’re looking forward to 2015 to save up post-tax money because that’s a sore point in our finances. Last thing, don’t discount maintenance costs, especially for older homes. I’ve found some shoddy repair jobs in the house and I’ve spent a little extra for quality parts, this increases the upfront cost but hopefully you’ll realize the gains with fewer repairs in the future.
For people in their 20s and early 30s with lower income — say, $50,000 to $60,000 — would you still advise them to max out IRA/401k and save what little they can in cash VERSUS saving a little more in cash which could be put towards a down payment on a house?
I understand how important saving for retirement is, but do you think there’s an opportunity cost to delaying home purchase, especially if you plan on living in it with tenants?
Good question. Depends how much you really want to buy a home.
I would at least contribute up to the company’s 401k match. You should look into the process of using some of your 401k to buy your first home.
Wow, I appreciate the lightning-fast response.
I’d like to own a home as soon as I can, assuming my finances are in reasonable order and I’m settled in my career. I say “reasonable” because with an income of $40k gross, I doubt I’ll have enough cash saved up for a 20% down payment on a DC-metro area home anytime soon (without neglecting retirement), even though I save 43% of post-tax income.
I’m 26 and got a late start working FT, but now that I’m getting my act together I was hoping to live in my own home by my early 30s due to the wealth it can build over time.
Do you have an opinion as to whether living with tenants would adjust your 30/30/3 rule?
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!
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!
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.
It’s because with a home, there’s a chance of appreciation. With a car, there’s a 100% chance of depreciation.
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?
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.
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?
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.
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?
Target no more than 30% of your after tax income to rent. Remember, you will never get rich renting.
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!
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?
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
Great guidelines. I like how you upped it to 30% downpayment instead of the 25% typically!
Gotta keep on saving now!! =)
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.
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.
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
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
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
Great recommendation and a simple formula.
hypothetical question : if you had enough $ to purchase a home up-front, in total, and still had a decent cash buffer, would you?
I have actually done that. I bought my first property on 100% cash and rented it out and continued renting in my current place. I did that because I only had enough cash to buy a studio apt but I was living in a 2 bedroom apartment.
This strategy enabled me to buy the apartment 4 years earlier and make 4 years worth of money from rent.
Furthermore, it gave me flexibility to keep moving different places based on employment opportunities without having to worry about leaving my owned home and then finding a tenant.
P.s. where I come from, renting a studio is waaaay easier than renting a 2 bedroom, as people usually end up buying it instead.
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.