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
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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.
Hi Sam,
Fed just said they will keep interest rate low for a very long time…
So, why do you think now is the peak of the market? It could be the beginning of a new rising circle?
The expectation of future appreciation def has an impact on how much one is willing to stretch today…
I’ve been saying since the early 2000s that interest rates will stay low for the rest of our lifetimes. And I have certainly said low interest rates for our careers since I started this site in 2009.
The low interest rate forever argument is the main reason why I have been arguing that homeowners should refinance or take out an adjustable rate mortgage instead of a 30 year fixed mortgage.
https://www.financialsamurai.com/30-year-fixed-mortgage-loan-vs-adjustable-rate-mortgage-arm-the-choice-is-obvious/
We very well could be in a real supercycle. This post is about being prudent and helping people who are searching for a home-buying rule to follow one or consider this one.
As we all know, there are no guarantees when it comes to investing.
Thinking that we are going to be in a low interest rate environment as a new concept is not correct. It’s been established, at least from my point of view, for 20 years already.
Thanks Sam.
I just went under contract for a house about 15% above medium home price in NoVa. I’ve been offered a jumbo loan 2.5% for 5/1 arm or 2.875% for 10/1 arm.
We will be in this house max 10 years, and perhaps just 5 years… What do you suggest us taking?
No advice on the option but glad you found a spot. Still in great falls or did you expand the search?
Great falls suddenly became so popular, especially any house with a pool! I feel it doesn’t make sense for us to endure a 20 min longer commute each way and still pay the same price as McLean (you do get bigger land in GF, but that comes with more maintenance cost, etc.). So we finally settled in McLean inside beltway, where I’m currently living in a townhouse. Planning to rent out the townhouse when move to the single.
How’s your house hunting going?
Great article and timely as my wife and i are currently looking to buy a home. We comfortably meet the first 2 requirements for our targeted price point, but do not meet the third. We are looking to buy a home worth around $1.5M and would finance the entire amount and use our securities as collateral to “pledge” as a down payment. Our monthly “all in” payment would likely be around $8,200 (with taxes/insurance) a month or $98K annually, which is around 22% of our household gross income of $435K. It seems I hit this parameter even when financing the entire purchase.
We have more than the home value saved…Excluding retirement accounts, have $2M in taxable brokerage accounts. Only 200K in cash, but bc I am not putting a down payment down, do not think that is too important.
However, we would fail the third test as 3x our annual HH income is only $1.3M….Unlikely we find a house below $1.5M.
i would appreciate the perspective of others as I am in my mid 30’s with a growing family. We have $2.5Mish of total assets.
Thanks!
The 3X multiple is a general home-buying guideline. Due to a collapse in mortgage rates, stretching to 5X your annual gross income is now equivalent to 3X when mortgage rates were much higher.
You can view my home-buying rule as 3 separate rules, are a 3-in-1 rule. Ideally, a homebuyer fulfills all three rules. But if a homebuyer can get 2 out of 3, that’s pretty good.
Perhaps your income will grow to $670,000 in several years to get that $2 million house you want today. Only you have a great idea.
When I bought a $1,520,000 house in 2005, my income was around $300,000. I was SWEATING BULLETS three years after I bought due to the financial crisis. Luckily, I didn’t get laid off. But I put down everything I had… .$320K and had no savings for a while.
I went all in and almost lost a lot. It was mainly luck that I held on and finally sold in 2017 for $1-$1.25 million more than I was trying to selling in 2012.
At least now, you know that the great economic suppression is upon us. Maybe we will rebound, maybe we won’t. But at least you see right in front of you what is happening.
Thanks for the quick response Sam, helpful perspective. It’s certainly possible my income will go up materially 8-10 years out, but do not have a ton of visibility and it’s more likely to stay flattish for next few years. Additionally, we will have additional expenses associated with an expanding family hopefully one day.
I guess I feel I have a slight margin of safety in that I have a decent NW saved, yet my income isn’t as quite high relative to purchase price. There isn’t a way we could swing 5x, which is over $2.1M without a sizable down payment or comprising heavily on savings.
Is renting while you save up or cash or until you find an opportune time to sell other assets not a viable option?
I would just use my securities as collateral imstead of putting down a down payment so it’s not a function of savings… It’s just going from currently renting to buying will more than 2x my monthly payment and I will save essentially 45K less a year, albeit my quality of life will go way up plus some of that will go to chisel down principal I suppose. I also do not imagine much appreciation in the suburbs of NYC, short term as the city continues to flood out to the burbs prob keep market solid, but do think demographically I would settle for inflation like returns over the next decade or two I would be thrilled
Hi, im 37 years old. I make nowhere near the 100k you mention (i work on my own), but i started saving and investing in my very early 20´s. My situation is this: i have 6 properties (3 apartments, one land lot, and 2 old houses i bought very cheap in the historic center of my city and later remodeled for renting).
the apartments and the landlot are already paid. I have one mortgage for each of the old houses.
I havent paid a single penny on rent or mortgage in the last 12 years, as all these properties generate income, so it pays all for itself. One apartment and the two houses have more than doubled in value since i bought them. the land lot hast increased in value more than 20 times.
My question is this: i have always saved and invested, but actually never had much cash in the bank. I have a preapproved mortgage for another downtown house. should i keep going?
Sounds like you have a high risk tolerance. You have also ridden an amazing bull market. The key is to not get overconfident.
I would build some cash savings for sure.
Great job with this article. I think these rules are simple and easy to follow. The 3rd rule, buying a home worth 3x your annual salary was also featured in the book the millionaire next door. You know what you’re talking about.
I feel as though this 30/30/3 is still a little too aggressive and overspending for my taste, but acknowledge there’s are limited options in coastal states even at 30/30/3 for a median income household.
My wife and I combined would be able to afford a $700k-750K house based on the 30/30/3 rule, but would much rather keep the purchase price in the $500k range if not below, mortgage payment will stay somewhere between 15-20% of gross income. Investing in a primary residence is certainly one way to grow our networth, but it’s still a mental challenge for me to spend more money. Feels a bit frivolous to have a nice yard, private driveway, garage, and more room than we actually need when a dingy 2 bedroom apartment worth $300k would provide the utility we need.
For the third rule, it makes more sense to limit the debt on your property to 3X salary than to limit the value of the property. I could have a $1m property with $300k debt in it.
Sure, if you have a $700,000 down payment and a $100,000 income.
But I would say that is a rare combo to have 7X greater your annual income in the form of a DP.
But if you do, thanks to a big windfall or you score a great deal, 3X debt works as well.
Just to clarify, are you suggesting that only the top 1% (household income $500,000/year) should buy a median-priced home in San Francisco (~$1.6 million)?
That’s one way of putting it. However, I do discuss going up to 5X with the decline in mortgage rates. A $320,000 household income for two 30-something year olds is quite common in SF.
Further, assistance from parents or relatives for the DP, which is common here, muddies the rules.
I’ve counted 5 neighbors whose parents either bought their house for them or inherited their house.
The goal is to follow all three rules. But if not, to follow at least one of the rules.
Good advice Sam! But isn’t Rule #3 basically the same as rule #1, but with a more conservative income requirement? If you pass rule #3 you will almost ALWAYS pass rule #1
Could be! Rule #3 is a quick way to screen for homes in an affordable price range. Following Rule #3 is the final insurance to follow the other two rules. The rule also helps homebuyers think in a different way.
It also takes into consideration down payment percentages and prevents one from stretching too much with a high DP.
For example, let’s say you make $200,000 and have a $1 million down payment. You may be tempted to buy a $2 million home since you can put $1 million down. But then you would be left with nothing and a $1 million mortgage which may be too risky. Some people get very aggressive, which is what I’m trying to prevent. I think they cannot lose, but sometimes they do.
Instead, you could buy a more reasonable $600,000-$1 million home. You could pay all cash or you can put a down payment and diversify the remaining funds.
Does the 30/30/3 Rule also apply when building new residential construction for existing homeowners?
I’m preparing to build a single family home with an ADU in the Bay Area Peninsula within the next 2 years. From my research so far on lending rates, I’ve seen residential construction loans (compared to a traditional mortgage) are still a bit higher than home mortgage rates.
Hey Sam,
I wanted to first say I actually agree with pretty much everything in the post.
But I wanted to come at you with a slightly different perspective. One mainly focused on the lower to middle class you mentioned.
I make about $50,000 per year. I bought my first home when I was 26 (now 30). I took out an FHA loan on a $185,000 home with not much else in the bank after the matter. The key was: I bought a duplex. (There are programs such as Freddie Mac Home Possible where you can put 5% down on multi-unit properties while having greatly reduced MI, but that wasn’t an option for me at the time).
Anyway… my mortgage payment was roughly $1,350 per month. That’s a little over 32% of my gross monthly income which admittedly isn’t far off your first 30% rule but I was far away from meeting the second 30% rule in having any sort of semi-liquid funds nearing $55,500.
The thing that makes it work SO well for lower-to-middle income earners like myself is the clear and obvious point: rental income. In my area, rents range from 900 on the lower end to 1,400 per month for a 2 bed 1 bath unit on the high end. I immediately went out and rented my unit after basically just painting the place for $1,050 per month and all of a sudden my rent/mortgage payment was now $300/mo or 7.2% of my gross monthly income. This allowed me to not only begin stock piling cash in my retirement accounts, but also allowed me to make some huge improvements to the home, save up funds for future repairs, and also have some for entertainment/travel.
I try to preach to all my friends who are in similar financial positions that if they’re looking into home ownership and don’t necessarily have the funds to put 20% down AND have some extra cash laying around for those repairs that will most DEFINITELY come up, this is the way to go. Rents historically increase. While property taxes tend to increase (albeit at a slightly lower rate), you’ll always have that fixed mortgage rate to prevent your payment from getting out of hand. I’ve had a few friends buy into it and are loving the life. It allows those people who don’t make 6 figures (or 7) to get into the home ownership game, start building equity, start saving for retirement, and start building a better life for themselves.
What do you think of this approach? I’m looking for my second but not immediately ready to pounce given housing prices right now. By taking this approach, I can grow a “business”, generate more income, and eventually semi-retire with a passive income stream (hopefully early!)
32% is not bad. However, know that housing market has done very well over the past 8 to 9 years. If we are in a 3 to 5 you’re downtown, I could be more difficult. What if your tenants leave? What are your tenants don’t pay rent?
Many of us have made a lot of money in the stock market and real estate market since 2012. It’s important we don’t confuse brains with a bull market. We must all ourselves every time we look at our net worth and our investments that it was mostly luck, not skill that has made us wealthy.
To clarify, did you rent out a room or did you rent out the whole place? I like the idea of buying a place and then renting out a portion of the property to lower costs. That’s what I did for 10 years, and what many other people do who are first buying a place.
Excellent point… I rented out the one side, then rented out one room of my unit to my good friend. So I was fortunate enough to actually be making money and living for free.
Agreed. I have done this with my rentals in the DC area as well. I find you can get a better return by splitting up the rooms in a home and renting them individually, rather than renting the whole unit as you can charge each room at a premium for their percentage of the whole. I also find that turn over mitigation is easier when trying to rent out a single room versus the whole unit. In the past I had longer term rentals 18 month terms or so for the whole unit. I found it more time consuming to land a tenant, but once the headache was over It was locked in for 18 months or longer, ideally.
More recently, I have allowed 6-12 month rentals largely due to the fact that the turn over was so quick. I also found a connection with military tenants as well. Considering they need to be flexible I dediced to be as well. It has worked out for me. I had a tenant move out on a Wednesday and had thier replacement signed up by that Friday. I would say I could chalk it up to luck, but this has happened three times in a row so far. Definitely split up the rooms if you can (and your rental area supports it).
I just wonder how feasible is splitting up the rental in pandemic? Will that scare off tenants?
Certainly a concern, but I look at it as maybe one room takes a hit versus the whole unit. So in a sense it protects you. With that said, I’ll see how the next 4 months go. Next reup is around then.
The awesome part about my particular area is it’s such a HOT, hip-to-live area that people are literally lining up waiting for units to become available. Renting out my unit will take one afternoon of showings.
I just happened to buy in at exactly the right time. It’s one of the only cool suburbs to reside in the Cleveland area :P
I like the 3x limitation and I still think you should strive for it even in times of historically low mortgage rates. We are under 2x on our multiplier and I would have paid less if I could have found something that fit the bill.
We paid extra for the school zone though, which saved us a lot more than the extra $50-$100k we could have saved on purchase price in a bad district.
I’ve got 825k mortgage and been charged 8.25 as I’ve prepaid my payments for one year. My home was evaluated at 3.4 m but likely should hit the market for 3.8 to 4.2m.
For 10 years I’ve been juggling without my son’s father. I’ve made about 100k each year maybe more some years. I rent my main floor and spent 150 k to gut my basement and fetch 1850 for it per month. My main floor has rented for 5200 each month. The issue is property taxes are 13 k and expenses maintaining this 1880 home have been very high.
Toronto Ontario Canada where I live has an average cost of 1 million for a simple war time style home.
I’ll be 55 in Feb 2021.
I’m scared and freaked out to move as Some experts say I should rent or make a drastic life change.
My son is 21 and this home is all he has known.
I don’t know what to do but I’ve felt for years owning this home is becoming increasingly difficult and extremely stressful.
Good article. Why didn’t you include property taxes?
Thank you
Sure, the homebuying rule takes into consideration the affordability overall and all normal expenses.
I agree a lot with the second rule to have 30% saved up though I recognize that is difficult for a lot of people. You contradicted yourself on the third rule with your example though.
You said that a person making $100k a year should limit themselves to a $300k property yet in your example you showed a person making $100k and buying a $400k property. What am I missing here?
Personally, living in Southern CA (or northern too, like yourself) a $300k property is the equivalent of a one bedroom condo, possibly two in a sketchy area though. Good luck with that. You can expect to may more for even a modest home. My income was a bit over $100k 10 years ago when I bought a $600k property. Seven years later it was paid off. It’s doable if you’re disciplined.
There’s another example below it that includes sticking to 3X annual income. Because mortgage rates have dropped so low, it’s become very tempting to increase the multiple. I do think stretching up to 5X your annual household income is less risky now that you can get a mortgage below 3%.
But when you start violating all the rules, that’s when people can get in trouble.
Really helpful examples and smart guidelines on home buying! With so much uncertainty now it really makes sense to utilize this type of affordability check before making a huge purchase on a home. Thanks for the tips!
Hi Sam, Are you only looking at the monthly mortgage P&I, or are you also looking at property taxes? (and insurance) While P&I can decrease over time with lower interest rates and refinancing, property tax can’t be ignored. Our montly property tax is now nearly 40% of our monthly P&I. Even if we pay off our 3.25% mortgage with a 50% loan to value, property tax doesn’t go away.
Hi Sam,
Question about the 30% saved in cash, 20% of which is for a down payment. You say the other 10% is for a cash buffer. Is this in addition to the 6-12 months of cash you think folks should have on hand anyway or is it a separate cash buffer just for the house?
10% cash or liquid securities is the minimum. Home that will last at least 6-12 months just in case anything happens. It should.
$300k house, $30K cash, can pay 10 months at $3K a month. Is enough IMO.
I was googling “VA home loan financial samurai” to see if you had any strategy of news the program. Everyone situation is different, some veterans don’t have to pay the funding fee (2%+). Also in 2020 the VA lending cap will be removed. A family could walk into a million dollar home paying nothing but closing costs. I would like to hear your thoughts!
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.
I agree this is conservative Sam talking. Did he make his purchases within these parameters?
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..
In no sense is money spent on rent “wasted”
agree. I would have stayed in my rental for much longer if family planning necessitated moving. the monthly savings on a cheap apt in a HCOL area cannot be understated.
Folks should check out BURL: https://www.financialsamurai.com/real-estate-investing-rule-rent-luxury-buy-utility/
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.
Dont rent a home, rent an apt. if homes are 500k, rent should be 600-800 bucks for a 1 BR.
I live in an area where homes are 1-1.3 mil on average and I rented for 1700 in a great neighborhood.
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.