If you're trying to figure out how much to spend on buying a house, the best home-buying rule I can offer you is my 30/30/3 home-buying rule. I came up with the 30/30/3 home-buying rule back in 2009 during the global financial crisis. Since then, many publications and industry pundits have promoted it since.
If you follow my home-buying rule, you will have a greater chance of surviving any financial downturn. My 30/30/3 home-buying rule will also help you keep you disciplined when buying property during a hot market like the one we're in now.
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. But ideally, you follow two or more parts of the three-part home buying rule.
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. Work from home is growing and people want to own a real asset that appreciates in value over time.
My housing market outlook over the next 10 years is positive. However, I also expect home prices to fall by 10% – 20% from peak to trough after a surge in mortgage rates. But I expect inflation and mortgage rates will fall again, boosting demand for housing once more.
I just want all of us to buy a home responsibly. 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 is my 30/30/3 home-buying rule to follow. The goal is to follow each part of the 30/30/3 home-buying rule to be a financially responsible home buyer. If you can’t, you must follow at least one.
Home-Buying 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.
Home-Buying 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.
Home-Buying Rule #3: Limit the value of your target home to no more than 3X your annual household gross income.
The final part of my 30/30/3 rule is great for doing a quick scan at homes you can afford.
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.
If mortgage rates are declining and you're bullish about your income growth, 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.
With the expansion of the multiple up to 5X, you can also name my home-buying rule the 30/30/3-5 rule. But I wouldn't spend much more than 3X your household income on a home if your mortgage rate is over 6%.
Home-Buying Examples Using My 30/30/3 Rule
To help illustrate my home-buying guide, here are some examples. Buying a home is an incredibly emotional process, so it's good to run through the numbers. The last thing you want to do is buy a home and feel stressed every night about your finances.
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.
When mortgage rates are low, 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.
Don't forget, there was once a time when most home buyers bought homes with cash!
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.
Another 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
- Pay cash for a home
Income And Net Worth Necessary To Buy A Home Using The 30/30/3 Home Buying Rule
For those of you looking for an easy chart, here's one I created that shows how much you should make and what your net worth should be before buying a home. The recommendations follow my 30/30/3 home buying rule.
Have Discipline When Buying A Home
I get your desire to own a nice primary residence (another home buying rule based on net worth). 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. Here's a podcast episode where I talk to my wife about overcoming the emotional stress of buying a new home.
Keep Housing Expenses To A Minimum For financial Independence
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 the FI 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! I expect the real estate market to stay strong for years post-pandemic. But that doesn’t mean you should go overboard when buying a home.
Real Estate Recommendations
1) Explore private real estate 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 with diversified eREITs focused mainly on Sunbelt real estate. Fundrise is free to sign up and look.
If you like to invest in individual real estate opportunities and are an accredited investor, take a look at CrowdStreet. CrowdStreet focuses mainly on real estate opportunities in 18-hour cities, where valuations tend to be cheaper and growth rates tend to be higher.
Personally, I've invested $954,000 in private real estate to diversify my real estate exposure, take advantage of lower valuations and higher rental yields across the country. As I get older, I also want to simplify life and earn income more passively. The spreading out of America is a permanent trend post-pandemic.
2) Shop around for a mortgage
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 still very low, but they are ticking up. Take advantage and save. Mortgage rates are finally coming down again after so many rate hikes since 2022.
The 30/30/3 Home-Buying Rule is a FS original post. FS has been around since 2009 and is one of the largest independently owned personal finance sites in the world. Everything is based off firsthand experience. You can join 60,000+ others and sign up for my free weekly newsletter here.