#3: Buying a Home

This is part of a series in which we re-evaluate Money Magazine’s “25 Rules To Grow Rich By”. One “rule” will be re-evaluated each weekday until the series concludes; you can keep tabs on the action at the 25 Rules index.

How Much House Can I Afford?

Rule #3: Spend no more than two and a half times your income on a home. For a down payment, it’s best to come up with at least 20%.

This rule is a fine one if you have little or no outstanding debt. However, many modern first time home buyers are often straddling a debt load equal to as much as a year’s income just from education, and thus using this rule of thumb can quickly put people into a frightening danger zone.

The reason is simple: once you reach a level where you have more than two and a half times your annual salary in debt, your payments on that debt will be pushing 40% or more of your take home salary. If you figure that you’ll be paying 25% of your salary in taxes (income, sales, etc.), that means you’re left with only 35% of your annual salary for all of your needs and all of your savings. Even if you cut back to saving only 5% of your annual income (which is itself a danger), you’re going to only have 30% of your annual income to live on, which is also a flag-raiser. If you’d like to do some calculations along these lines, use Smart Money’s debt calculator.

The threshold of a 20% down payment is pretty clear, especially if you’re already holding significant debt. The additional cost of having less than a 20% down payment, which means high interest rates on an ARM or paying PMI along with the extra debt burden, will put you in a very precarious financial situation.

However, if you have more than 20% you can use for a down payment, you don’t necessarily want to dump all of it into the down payment. If you are confidently able to exceed your mortgage interest rate in other investments – and there are a lot of investments out there that can beat the 6-7% threshold – you should strongly consider investing the remaining money after you have the 20% down payment. Plus, if you were to run into financial problems at a later date, you can access that extra money without tapping into your home or refinancing your mortgage.

In short, this rule makes sense if you’re a timid investor or if you have a lot of money in the bank, but if either of these statements exclude you, it’s time to rewrite that rule:

Rewritten Rule #3: Go no more than two and a half times your income in overall debt to buy a home. For a down payment, only exceed 20% if you don’t think you can beat the interest rate in investments.

You can jump ahead to rule #4 or jump back to rule #2.

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