If you look around the web there are a whole host of suggestions on what the “right” or “best” percentage of your income can be spent on a house.
Today we’ll look at a couple of methods that suggest what you should budget for a house.
I’ll also share what we’ve done through the years and my recommendations on what to spend when you buy.
The Highest Percentage
Most banks, home buyers, and real estate agents are on the same page when it comes to home buying — they want the most expensive house the buyer can afford. The bank wants it because they can lock in interest for a long time. The buyers want it because they want the biggest house in the nicest neighborhood possible. The real estate agents want it because they earn commission based on the selling price. So all three usually work together to try and get the buyer into the priciest house possible.
Obviously, this is less than optimal for the buyer, but we’ll get into that later.
For now, let’s explore some general guidelines on what a person should spend when they buy a home.
The standard options are different takes on the (mostly) same numbers: house cost and gross earnings. One method simply uses monthly numbers while the other uses total/annual numbers. Let’s look at them both.
Percentage of Gross Income Method
The first method we’ll look at is percentage of gross income. This basically says you should spend up to a given percentage of your gross monthly income on a house.
If you need help determining what’s recommended for you, here are some calculators I found by Googling a bit:
Each of these takes your personal information, looks at the market you’re in, and assigns an amount you can afford based on a percentage of gross income.
Or if you prefer you can take a more general approach. Money Under 30 lists the following rule-of-thumb guidelines:
Your maximum mortgage payment (rule of 28): The golden rule in determining how much home you can afford is that your monthly mortgage payment should not exceed 28 percent of your gross monthly income (your income before taxes are taken out).
Your maximum total housing payment (rule of 32): The next rule stipulates that your total housing payments (including the mortgage, homeowner’s insurance, and private mortgage insurance [PMI], association fees, and property taxes) should not exceed 32 percent of your gross monthly income.
Your maximum monthly debt payments (rule of 40): Finally, your total debt payments, including your housing payment, your auto loan or student loan payments, and minimum credit card payments should not exceed 40 percent of your gross monthly income.
These are standard guidelines that I’ve seen on many sites and get you in the ballpark of what you COULD spend.
Number of Times Gross Income
An alternative option is using the number of times gross income method. This post lists home affordability based on house cost divided by gross annual income. It offers several perspectives which suggest that a buyer can afford a home somewhere between 2 and 5 times his gross annual salary.
That’s a pretty big range, so the post goes a bit deeper, does some calculations, and comes up with a consensus number of around 3.5 times. Thus if you make $100k per year you can afford a house worth $350k.
But What’s Best?
Both methods give you the maximum amount you should pay under each scenario. But is maxing out your home cost the best option to grow your net worth? If you’ve read my post on how to buy a home and pay it off in 10 years, you know the answer. 🙂
Here’s what I said there:
Buy a house you can easily afford, putting at least 20% down. What’s a house you can afford? It’s one that fits into your budget after you look at all the costs, including both the house itself and the costs associated with home ownership. It’s also a house that leaves a bit of room in your budget for unexpected events and emergencies, not one you have to stretch financially to afford. It’s also a house that allows you to keep on saving for your other needs like retirement and education costs for the kids. Lastly, it’s a number YOU determine, not one that the bank (who wants you to borrow as much as possible) gives you.
In other words, you need to develop a budget and know what you can afford. And leave in some wiggle room too. Then YOU tell the bank and your agent what you’re willing to spend. They don’t tell you.
Only this way will you know that you’ll get a home you can afford and hopefully be able to pay off much faster than your mortgage calls for.
What We Did
I’ve already shared the cities we’ve lived in but I thought it would be fun to go through them and compare house costs versus income. This way you can see how the relationship between the two played out in helping us build our net worth.
I’ll only use the cities where we were married (I’ll skip the ones I lived in before I got married). I’ll also use the ratio at the time we bought the home (obviously our incomes went up during the times we lived in each place, making the ratios better).
Thanks to Quicken and tracking our financials for 22 years, I have the data. 🙂
The results:
- Pittsburgh: House was worth 1.17 times income
- Nashville: House was worth 1.38 times income
- Grand Rapids: House was worth 1.13 times income
- Oklahoma City: House was worth 1.10 times income
- Colorado Springs: House was worth 0.93 times income
A few comments on these:
- The ratios are low — nowhere near 3.5 times. This was key to us growing our net worth. Because we initially bought low and paid off our house when we lived in Nashville, we had years of no debt which saved us a fortune. We then invested that money in index funds and eventually our properties to drive net worth higher.
- The ratios held steady through the years. Our Oklahoma City house was our most expensive ever (Colorado Springs is close), but because my income was so high (combined with our rental units) the ratio remained low.
- We did not suffer. Some of you may be thinking that we lived in run down areas or bad parts of town. The smallest house we lived in was probably 2,300 square feet, none of the homes were older than 15 years when we bought them, and they all were in very nice neighborhoods. So we didn’t compromise quality of life to be better off financially. If anything, we could have purchased smaller homes for less money and still been fine.
- The cities made the difference. Some of you are probably saying, “Yeah, but you lived in low cost-of-living cities that allowed you to do that.” Exactly. That’s the point I made in Become Wealthy by Having a High Income in a Low Cost City.
- We didn’t suffer (yes, I know I said that previously). Some of you are probably saying, “Yeah, but you lived in ____________.” (meaning the cities we lived in were far from glamour spots). Let me respond bluntly: I’m from Iowa. Compared to the town of 3,000 I grew up in, every place is a mega-city with tons to do. I’ve lived in a big city (DC when I was in college) and have visited pretty much every big city in the US. I actually prefer mid-sized towns that have enough to do but don’t have the traffic hassles, crime, and so forth that many big cities do. I’m not disparaging New York, LA, Chicago and the rest, just saying those are not my cups of tea. Your opinion may be different.
Not only were the house costs versus income numbers interesting, but as I dug through Quicken I started to look at housing costs versus net worth as well. Here are those numbers:
- Pittsburgh: House was worth 4.12 times net worth
- Nashville: House was worth 0.73 times net worth
- Grand Rapids: House was worth 0.37 times net worth
- Oklahoma City: House was worth 0.14 times net worth
- Colorado Springs: House was worth 0.12 times net worth
Not much to say here other than the house values stayed the same/went up slightly while net worth exploded. The fact that our home is currently only 12% of our overall net worth (or actually it was when we bought it — it’s now about 11%) is nice.
Conclusion
So where does this lead us? The wrap up:
- Ignore what the “experts” and rules-of-thumb say when you decide how much to spend on a house.
- Instead, develop a budget, decide what you can afford, and buy a house accordingly.
- Use my method for paying off your mortgage in 10 years or less.
- Once you do that, you can super-charge your investing. (By the way, I didn’t compromise my saving/investing to pay off my house early. If you are purposeful and grow your career/income, you can pay off your mortgage early AND save/invest at the same time.)
If you take these steps, your net worth will thank you. 🙂
Although my wife and I have lived in a number of cities, we only just recently bought our first house (in Charlotte). We knew we weren’t going to be long term or permanent residents in the prior locations, but are now ready to plant some roots with our growing family. So my experience is limited, but I was actually surprised when talking with the banker and asking him how much we could afford that he actually avoided the question and put it back on me as to how much and big of a house I thought I wanted / needed. I was impressed and a little surprised. But it worked out that we found the home right for us and fit easily within our budget (looking back now it was about ~1.4x our gross income).
Just because you can (that is buy a house 3.5 times your salary, 28% or any other voodoo ratio) doesn’t mean you should.
I believe this is how so many people got into loans they could not afford before the housing collapse. They maxed out and found out they could not afford it.
Correct.
Great post. I have never paid more than 1.3 times my income for a house. I also have never had enough money for a 20% down payment to purchase a house. In 1992, I had acquired a 30 year mortgage through a FHA loan with 3.5% down payment at an 11.5% interest rate. Five years later, I refinanced my loan to a conventional 30 years loan at 6.5% interest and applied additional money to the principal to avoid paying the PMI insurance. In retrospect, I should have obtained a 15 year mortgage. I however did not plan keeping the house long term. My income has increased through the years and I purchased another house.
I would agree that if possible put down a large enough down payment to avoid the PMI. Refinance for a lower interest rate and if you are planning to keep the house obtain a 15 year mortgage. You can apply additional money to the principle and pay it off in less than 15 years.
You mentioned housing cost vs. net worth. In calculating your net worth, what did you include in the calculations? When I calculate my net worth I use 1) cash available 2) value of possessions such as car, jewelry— using insurance value 3) IRA and 401K 4) value of my house minus my total debt.
I calculate net worth as all assets less all liabilities. I don’t exclude this or that one way or the other.
I have no “official” debt, but I do have fake liabilities set up in Quicken for my kids’ college costs. These are equal to the amount I have in their 529s.
Everyone has some liabilities albeit they maybe small but are constant. Insurances–car, health, life, umbrella and possibly long term care. Utilities, property taxes and property maintenance. These cost can increase over time. The more you own requires maintenance and insurance.
I wouldn’t classify those as liabilities, I’d call them expenses.
If you did have things you owe in the future as liabilities, you’d also need to classify future income as an asset, right? That would be messy accounting.
Not to be too much of an accounting nerd, but I list income/expenses on a budget/cash flow statement whereas assets and liabilities are on the net worth statement/balance sheet.
I posted before on the old site how we are surrounded by people who bought way too much house; they are now in a variety of circumstances that I could write an entire blog post on. We don’t take pleasure in their misery, but we are glad we bought a small house (in one of the most desirable areas in our city – it’s the land not the structure). Now it was expensive, apparently 1.9x per the ratio above, but we still managed extra payments and are on track to be mortgage free next year, a total of <6 years. It was blogs like this that convinced me to not go in heavy: I did the math, found out what was an acceptable monthly mortgage (I preferred % of take-home income for our purposes), and we managed to to find a place that ended up being a few percentage points below my target monthly proportion.
I also think the people we bought the house from had a good plan. They didn't buy a house that would be big enough for the family they may have one day like so many people do. They bought a small house, lived here for several years, and when they were ready to start a family, THAT'S when they moved to a larger home in an area with good schools.
We’re in our fourth house in 20 years. Apparently we’ve learned some lessons because on this one, we decided how much we could afford and then went to the bank to tell them how much we wanted to borrow. I’ve used the online calculators to see how much they say we could afford and it astounding to me. I really cannot afford to spend what they say I can if I want to live life, save for retirement and help my kids with college. Unfortunately, it’s a trap many people fall into.
What is True Affordabilty? If you don’t have the Cash pay for the stuff, you can’t afford it. The stuff includes cars, any artifacts, and houses.
I bought the house I live in (home) with Cash. I don’t care if the world blows up. I sailed calmly through the storm of mortgage crisis of 2008-2010. I live in a city the house price is 8x to 10x median income.
“What is True Affordabilty? If you don’t have the Cash pay for the stuff, you can’t afford it.”
This is not true for long term assets that have other costs associated with not buying them, especially when starting out.
For example: buying a house versus renting one.
Buying a comparable sized house to the one you would rent is almost always the more affordable thing to do whether you have the cash for it or not. How do I know? I am a landlord. I make tons of money using debt to buy property that people paying rent for. It is far cheaper for me to own the house with debt than it is for them to pay the rent. That is how I make money. And that is how it is less affordable for them than if they owned it even with debt.
Other examples:
Buying a car versus having no way to get to work to earn your income (doesn’t have to be an expensive car but even a cheap car may require debt when someone is just starting).
Buying business assets that you need to produce products you sell versus not producing products.
I would list college here but I no longer believe it is a universal positive cost/benefit payoff. It makes sense for some but not for many others who are currently attending so using debt for it is far from a certain payoff for many.
Taking the 100% purity pledge on all debt all the time leads to this kind of mistaken financial approach.
Optimal finances and affordability actually requires debt especially in the early stages. Taking a no debt ever pledge will result in sub-optimal affordability.
NOTICE: I am only responding to the statement that debt is not affordable. There are other downsides like the risks associated with debt, but it is simply not true that the most affordable option always means no debt. Using debt in some situations is cheaper and more affordable than not using it.
My wife and I purchased our first house 5 years ago and it was at about 2-3x our annual income. We had not even started our careers. Today we are about to refinance our house for more than we initially paid (still under 75% of value though) to replace siding & windows that are really needed and it will be at about 1.8x annual income but our cash flow will increase as well because our debt payments are actually decreasing.
I agree that house to income is a bad way to buy a house…a lot can happen in 30 yrs time and income is not guaranteed to be steady nor rising. I’m more in the camp of save up and pay mostly cash for your primary residence.
Questions for your readers:
What is the optimal (or perhaps max?) house to net worth percentage at retirement? Does it even make sense to look at it this way? Do most multi-millionaires have their houses paid off?
Separately, what are your thoughts on buying a less expensive house in neighborhood vs. more expensive? I think Thomas Stanley in Stop Acting Rich alluded to getting one of the more expensive ones in a middle income neighborhood as to not have to keep up with Joneses (who on average are not making good financial decisions). After all, expenses run in packs…big house, expensive cars, private school and on and on.
Well, I’ve done both — bought an average/less than average hose for the neighborhood as well as a higher priced home in a neighborhood.
Key for us has been that the neighborhoods were reasonable to begin with. It’s a lot different buying an “expensive” home for $300k within a reasonable neighborhood versus an inexpensive home for $800k in a posh neighborhood.
I think Stanley was talking about the latter — a high priced home overall and all the maintenance, insurance, etc. that goes with them PLUS the “keeping up with the Joneses” costs like expensive cars and the like.
I followed you over from the old blog, which I was just getting into when you switched. Love the site!
So, I go back and forth on how much home I can afford and wouldn’t mind some thoughts. One thing I’ve always wondered is at what income do either of these benchmarks become less relevant?
I’m 38 and married, living in Silicon Valley. I’m a manager at one of the large tech companies and my wife is an accountant. We’re blessed to have great jobs and combined we’re making around $700K a year. But with federal ($175K) & state ($70K) taxes (plus we tithe – $70K), our take home pay is quite a bit lower (closer to $450K).
Homes are incredibly expensive where we live so we started renting when we moved here 4 years ago; we currently pay $3,800 a month for a 2 bed/2 bath. I’d also add that property values rise 8-10% a year where I live, and even during the recessions it has not gone down more than 10% or so. Outside of our rent, we have daycare for our son ($2,300 a month) and then assorted living expenses (I’d estimate that’s around $2,000 a month).
So one way I’ve thought about it is that outside of housing, my expenses per month are under $5K. Our take home income per month is around $37K. Currently we take most of that money and split it between investing and building up a cash reserve for a down payment (or a large market drop).
But theoretically couldn’t I be spending something like $25K a month on a mortgage and still have plenty of cushion? I would never do that (although around here even that amount would not get nearly as big of a house as you might think). But that would allow me to buy more house than any of those rules of thumb would suggest.
Does that make sense?
$700k/yr = $58k/mo.
$58k * 28% = 16k/mo of house mortgage
That’s ~ $3m of house mortgage at 30yr/4.5%.
All good stuff here!
I am a small fish. I still rent, we are a couple with no kids yet. Salary is 95k, single earning family. Rented for 5 years now. Plan to buy a townhome. In my area it is <200k. So 20% downpay is 40k + closing costs. I currently have 50k in savings. So didn't want to risk it yet.
I could have bought a townhome 4 years ago, but didn't have enough for downpay at that time. Although few argued to put down as low as 5%. But I decided to rent it as I wasn't sure if I wanted to stay here or move jobs.
My wife and I live in a medium sized midwest metro area. Our criteria for purchasing a house last year was based more on how comfortable we were making the payment instead of a calculation but it ended up being approximately 25% of our net pay. We could probably have afforded more but it doesn’t do a person any good if they are uncomfortable writing the check every month. We didn’t follow the rules about a 20% down payment but we did put down 5%. It was nearly intolerable living with family any more (3 years of that…) since we had previously owned a condo for 5 years. Stashing away 20% – even using my wife’s entire salary – would have taken another 18 months since 2 of those 3 years were on one income.
spend as little as possible and don’t get caught in the trap of thinking your house is an asset. It is only an asset if it is being rented out and making you money. Otherwise it is a cost to you for having a place to live. yeah those are some small towns and backwoods places. I paid like 4x gross salary for the house I’m in now but as the salary increases it is like now only 2x so that is a good thing.
I agree that a house is not an asset. It does not make you money. For that reason, I would not put a large down payment to purchase a house. I would not want to be house rich and cash poor. To many things can go wrong within a 15 to 30 years period, which is the life of most mortgages. As your salary increases you can always put more money on the mortgage.
Great site. Great discussion. I remember you from the old blog as well.
I am in the camp that thinks debt has its place but only when used conservatively. Debt can be helpful but more often than not it is a burden. Not a blessing.
For a home- 20% down is a must. The size of the loan must not impair your ability to save for retirement. Retirement has no available loans — you are on your own. If you get to retirement without significant savings- you are screwed. That should be everyone’s first priority.
If that is on track and you are otherwise properly saving and have a decent net worth so that the 20% down on the home is not more than 20% of your net worth. Then you can safely take the plunge.
My other rule is that you should never take a loan that extends into your retirement years. You want to retire debt free. 50 year old people have no business taking 30 year mortgages. Don’t let anyone tell you otherwise.
Three years ago with an income of $100k, we bought a house for $350k and put enough down to only borrow $260k. Now, our income is $150k and we still owe $212k and the house is now worth $440-450k.
We’ve been considering taking the equity and downsizing to something we could pay cash for or have paid off within a year (projection is to pay off current house in ~5 years). We’ve found plenty of houses in the 250-300k range that we like that we could have paid off within a year but have been struggling with the idea of moving to an area with significantly lower rated schools. The cheapest homes in our current school district are ~350k and it’s hard to get excited about going through the hassle of making a move to only lower our mortgage balance by $50k.
Any advice?
If you have or plan to have kids soon, do not move to a school district that you are not completely satisfied having your kids in.
Any decision is fine as long as you stick with that first rule.
I agree with Apex.
If you don’t have kids, won’t have any, or if they won’t attend the schools (our kids were homeschooled), the school districts will matter only for resale purposes. The fact that they are below your current location’s schools is already reflected in the selling price, so you don’t have to worry about losing anything unless they tank even more while you live there.
If you have kids (or will have them) and want them to attend public school, then you need to decide the type of school that is acceptable and use that as a key decision factor.
Financially, one place isn’t that much different than the other in the grand scheme of things ($50k).
We’ve got one in public school and a few more behind that one, so schools are important for more than just resale purposes. For $50k lower price we could stay in our current schools but it’s not worth the hassle for me since it only speeds up the mortgage payoff by about a year and realtor fees could eat up a good chunk of that. If we went to the area with significantly lower rated schools we’d be looking at houses $200k cheaper for homes similar to the one we’re in.
A third option we’ve tossed around is staying in our same county/school district, but a different school that is still very good, just not the best. Doing that we could maybe get a house for ~$100k cheaper and speed up the mortgage payoff by >2 years.
It sounds like a quality of life/education decision as much as a financial one.
You can always buy a cheaper house. Even if you get the one that’s $100k less, you can find a cheaper one in an even lower school district. You need to decide what quality of education you want for your kids and go with that IMO.
Our kids were homeschooled, so we had more freedom, and even though our house was quite affordable, we could have moved to a less expensive one. But we decided for quality of life purposes to stay where we were. So money isn’t the only factor in where you live — even for a tightwad like me. 🙂
Another thing is you will have to incur selling costs when moving plus likely fix-up costs in the new place. Things to consider…
Do you have any advice for people who plan to buy a home overseas? What would be the tax implications? And if credit score ever a factor?
I do not, but Mike H may as he lives overseas. I’ll send him a note.
Hi Sam,
It really depends on where you are looking overseas, as local taxes and fees vary by locality. I do think you can apply for the US Federal tax exemptions based on living in the property similar to the US guidelines.
In many countries it is hard for foreigners to get a mortgage. In Thailand I believe the maximum value of a mortgage is 50% of the property value for a condo (foreigners cannot own land) so that means that one would need to come up with a very healthy down payment.
-Mike
Hey, I somehow missed this one when if first came out. I like the ratios, very impressive. I’m slightly embarrassed to admit that our house is 2.5x our household income. While I’ve always been a big saver, at the time we bought the house, I was not as focused on financial independence as I am now. If I was, I wouldn’t have bought such an expensive place. That being said, we love it, so there is that. And, we will have it paid off relatively soon.
If and when my kids ask me for advice on how much house they should buy, I think I’ll tell them that it should be between 100% and 150% of their income.
Thanks for sharing!
I always liked the rule in the millionaire next door. Buy a house that your mortgage is no more than 2X your income. That way, you can get wealthy.