The Home Buying Rule of Thumb

“It is in the eye of other people that ruin us. If I were blind, I would want, neither fine clothes, fine houses or fine furniture.” – Benjamin Franklin

Continuing on the theme of breaking down the 8 top financial rules of thumb. Next is “a house should cost less than 2.5 x your income.”

You finished your tax return, interest rates are still low, what a great time to buy a house! This is when you ask me how much house should I buy and what’s the rule? We could use the 2.5x income rule as a starting point… But really it depends. As with all rules of thumb: broadly applicable, not specifically relevant. The size of the house you should buy is dependent on many more variables than income such as:

  • Interest rates – higher rates smaller house
  • Family size/needs – you can’t fit 7 people into many 200k homes…
  • Age – a 90-year-old won’t enjoy 5,000 sq foot 2 story house
  • Living expenses – more expenses, less room for house budget
  • Location – A San Francisco shack is the price of a Kansas City mansion
  • Travel – the less time you spend in a home, you should want less maintenance
  • And so much more…

Think this rule still applies? Let’s break it down. For simplicity, you make $250k per year, have 2.5 kids, are 35 years old, and live in Anytown USA. Using this rule of thumb, you should buy a $562,500 home. A 30-year mortgage should cost about $2,800 per month with taxes and escrow after the 20% ($112,500) down payment. At $33,600 per year, 13.44% debt payments vs. income should seem reasonable.

Even here, there are problems. Let’s look deeper. Income is taxed for federal, state and FICA. You also save 20% for retirement so you can retire early and pay for health insurance at $1,000 per month thanks to employee benefits. Take home income after all that is probably around $110,000. So that 13.44% expense is actually closer to 30% of your income. Feels a little steep to me.

Why is that steep? It’s a great investment, right? You have 110k to spend. Take out $33,600 for the home. The 2.5 kids cost about 24k for daycare. Car payments on the two Beamers (or Lexus or Mercedes or whatever your taste is) total $17,000 per year. Oh and taxes, insurance, utilities, groceries and of course miscellaneous club memberships… The fixed costs alone bring you very near $0.00 disposable income after expenses. Maybe owning this home isn’t the best option right now?!

Moral of the story, a simple rule isn’t going to address all the variables in your life that should be considered when deciding how much home to buy. Equally important, the cost of the house you buy shouldn’t be based strictly on what the bank will approve you for, they want a big note on an asset they can take back if you don’t pay. Avoid being house poor. Do your research and seek professional financial advice to find your custom fit.

If you would like to know more about home buying and how it fits into your financial plan or the other topics covered in this blog, please call Ryan Forster at 913.681.9155 or email ryan@engageadvisors.com.

 

 

 

 

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