Updated on 08.28.14

#3: Buying a Home

Trent Hamm

25 Rules to Grow Rich By

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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  1. MoneyFwd says:

    Are you saying don’t allow your debt (all loans plus mortgage) exceed twice your take income?

    So if you make $100k a year, have $20k in debt, don’t buy a house worth more than $180k (after downpayment). Are you assuming that your savings (like downpayment amount over the 20%) offsets the total mortgage and loan amounts?

  2. BTW, the Money Magazine Rule #3 stated spending no more than 2½ instead of 2 times your income on a home.

    One thing that I don’t like about this rule is that it makes home ownership only available to high income earners where I live. I
    mentioned this in my blog, since I found it surprising that it would require an income of $144,000 per year to buy a median priced home in Massachusetts. Scary stuff…

  3. Trent Hamm Trent says:

    Exactly. You should never find yourself more than double your annual income in overall debt. So, if you bring in $100,000 and have $20,000 in debt, you should not buy a house costing more than $180,000.

  4. Jeff says:

    Trent — even after MoneyFwd pointed it out, you made no admission that you misstated Money’s rule — spend no more than 2 AND A HALF times your income on a home.

    Actually, I think both rules are oversimplifications because they don’t take interest rates into account, and you don’t take into account the KIND of other debt a person might have, and at what interest rate. You rule seems to forbid the use of student loans, by the way — by the time I sat down to my first college class, I had taken out a loan that was more than double my annual income. I sure hope nobody out there is taking this rule literally.

  5. Mousebender says:

    One obvious implication: Leave California!

  6. Roger says:

    The first part of the rule seems pretty sound, although, as Jeff noted, there are different kinds of debt; someone with $20,000 in debt at 4% is in a much better position to take on an $80,000 mortgage than someone with the same amount of debt at 18%, even if they make the same amount of income.

    As for putting 20% down on a mortgage if possible (and no more), that seems pretty sound.

  7. Kris says:

    I wonder if you think investing anything over 20% rather than increasing your down payment is still sound advice?

  8. Lee says:

    Here in the UK a >20% deposit is becoming the only way to unlock the good mortgage rates. If the difference between 20% down and 30% down is a 5% rate reduction (resulting in significantly lower monthly payments), I posit you’re better off making the 30%.

    If 30% and 40% saves you a further 2%, then it would make sense to make the 30% and invest the difference. A 2% return is not difficult even in our current economic climate. 5% is possible with care but the 7% would be unattainable here right now without real prolonged luck.

  9. Bonnie says:

    This sounds like a nice rule, but completely unrealistic where I live. Using this rule, assuming an annual income of $100K/yr, a 20% down and a total mortgage of $250K, you’d be able to purchase at best a 1-BR condo, which wouldn’t be a realistic living situation for an average family of 4.

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