How Much You Should Borrow when You Buy a Home

Here's another item on Money magazine's list of 25 rules to grow rich by. Today's tip is related to how much you should borrow when you buy a home:

Spend no more than 2 1/2 times your income on a home. For a down payment, it's best to come up with at least 20%.

Many buyers in recent years have stretched the limits of affordability, and have bypassed the traditional 20% down model. But make a smaller down payment, and most lenders will require you to have private mortgage insurance (PMI), which adds a minimum 0.5% of the loan amount to your mortgage payments, about $1,000 more a year on a $200,000 principal.

Good advice -- though millionaires make it a bit more extreme and only buy houses worth two times their income. Either of these probably works in my formula for buying a house, though I'd lean toward putting down a bigger downpayment and having a lower mortgage. Of course, I'd recommend paying off your mortgage early too, but that's not a popular subject. ;-)

For more real estate related posts, see these links:

• Six Cost-Effective Ways to Protect Your House This Winter

• Should You Buy a House With No Money Down?

• Best of Free Money Finance: Real Estate Posts

Comments

[Nagel]

My wife and I bought a home for over 3x our income, but put 20%. The mortgage is the same amount as our rent for the past several years. Are we up the creek?

[cory]

The 2x (or 2.5x) annual income rule doesn't sit well with me.

I believe in buying a house you can afford of course, but the dollar amount of your mortgage balance doesn't seem to make much of a difference to me.

Let's say your household makes $50,000/yr. Abiding by this rule, your mortgage range would be 100k - 125k, which is a reasonable mortgage for many areas in the country. Ok so next step would be the monthly payment, right?

If you took out the mortgage in 2003 of $100,000, the average rate was about 5.4%, giving a monthly payment of $556.

If you took out the mortgage in 1983 of $100,000, the average rate was around 13.4% for fixed rate mortgages. Making the monthly payment $1137

How is this a good rule of thumb?

[FMF]

Nagel -- I'd say you're ok. You have a good amount down and the same housing expenses as before.

[Lord]

PMI has largely been made obsolete through the use of piggyback loans which generally are a better deal as the higher interest on the second is deductible. There may be someone for whom a 0% down makes sense (a new pro athlete or corporate lawyer perhaps?) but extremely few command the requisite income.

As my brother says, you can buy cheap anywhere but you don't want to live in those neighborhoods. Buy something you can be happy with for quite a while, ideally forever, from both affordability, cost, and value.

[Skott]

The other key part of the MND formula is that you live in the house for a long period of time (20 years or more). So as your career develops and your income goes up, the mortgage becomes a smaller chunk of your budget. If you up-size at every opportunity, you're tying up more money in the house when there are other investments you could make with it.