MND: Buy a House You Can Easily Afford

Here's another post in our series on the learnings from the book The Millionaire Next Door. A quote from page 68:

Here is another one of our rules:

If you're not yet wealthy but want to be someday, never purchase a house that requires a mortgage that is more than twice your household's total annual realized income.

This rule has worked for us. Every house I've purchased and every house my wife and I have purchased have been worth less than twice our household's total annual realized income. (And since that first house purchase, our net worth has grown dramatically.) Yes, this meant that we have never lived in the "ritziest" neighborhoods in town and we didn't have a five-bedroom place on a lake, but we lived in nice middle class areas with friendly neighbors. This is certainly fine with us and it has been a key part of raising our net worth.

Comments

[javasoy]

We are in the third house that we bought. For our first 2 houses the mortgage were indeed less than twice the household income. But the current one is a little over. Why the difference? it depends on the circumstances. The book was written in the late 80's? I believe? Back then, interest rate was sky high because the fed wanted to fight inflation. What's assumed in the book was probably interest rate of at least 8 or 9 percent.

At what price point is suitable is a complicated subject. A better measurement is what is the percentage of the mortgage payment amounts to the monthly total after tax income. Cashflow analysis, my friend, is the key.

[Hazzard]

One of the senses that I got when I read this book years ago, was that it is more about not trying to keep up with the neighbors, as opposed to living in a better, larger house. We live in one of the better neighborhoods and have seen very high gains on our equity. The trick for us is not trying to keep up with our debt laden neighbors. While we have nice things, we tend not to drive 45K cars etc.
Hazzard
http://elym.blogspot.com

[RS1990]

Is this rule of thumb even possible anymore? It isn't possible here in New York, that is for sure. When a raised ranch in a bad school district is selling for $300,000, then this just doesn't work.
-Rick

[Debbie]

It doesn't work for me either--a single person with a salary lower than that of a first-year teacher. However, I was able to get a decent place for three times my income. I did this by getting a well-built but tiny house in a convenient but borderline area (near but not in less safe areas), and I generally have a roommate who pays me some rent.

[Soundsgood but...]

I live in a home that is worth roughly twice our yearly after tax take home. My problem is the same as Hazzard. Any shack in NYC suburbs is 500,000, including the one I'm in. We've looked around and no one is building anything under $600-900K. The tax bills are ridiculous. 20-30K a year which is more than double what I'm paying for the current mortgage and tax. I'm tempted to buy the biggest house boat I can find for cash and live on some lake.

[Nice idea but]

It's a novel idea for people living outside of a major metro area. Reality is, if you live on either coast line where real esate goes for a premium, that rule is impossible to follow. Just a guess, my house is likely worth 7x what my wife and I take home. Someday, when I retire, I can move out of state and buy something cheap, and my house equity from this home becomes a large portion of my retirement income.

[FMF]

I hope you decide to retire in an "up" market.

[Peter Cooper]

Great advice, but sadly becoming hard to practice. During the '90s it was easy, but now here in the UK 'average' home prices are routinely 5-7 times 'average' incomes even in remote areas such as where I live (no jobs, ages from major towns, etc).

[kassy]

The formula almost works with my dream of moving to the middle of nowhere, but living in Seattle, no way. Double my take home is $85,448 and according to an article in the Seattle Times last month the median home price in the city is $338,600. I've pretty m uch given up on ever being able to buy a home.

[the Prince of Thrift]

Very good advice, I am going to have to borrow that book from the library. Unless, I get it as a gift from someone, maybe at Christmas. I will have to put it on my Christmas list.

[Big Cheese]

Peter,

You have to get a job that pays a higher salary- that's all.

-Big Cheese

[Susanna]

we didn't have a five-bedroom place on a lake

Heh. We just bought a new house that *is* a 5BR place across the street from a lake. It's in a pretty small town in a part of the country where the cost of living is low, so it's still very affordable for us. It needs some work, but that's OK because we expect to live here for a long, long time.

[7million7years]

First of all, the 'rule' relates to having a MORTGAGE no more than twice your salary; so you can add whatever deposit makes sense, on top of that.

I recommend having no more than 20% of your Net Worth in your own home. So put these two rules together to calc what you can afford.

If that doesn't buy what you want, either:

a. Rent - but buy a smaller investment property instead

b. Move to a cheaper neighbourhood

c. Increase your income (as Big Cheese suggests).

Just make sure that you NEVER break the 20% rule. OK?

[azeem]

Ahh, what happens to this formula if you live in the Bay Area?
no more than two times your income here will buy you a big truck that you'll need to sleep in :<

[FMF]

azeem --

Your choices:

1. Make more money.
2. Rent.
3. Move.

This formula does not make any sense for people living in expensive metropolitian areas. I live in Seattle, and there is no way you could buy anything decent for less than $300,000. We are making more money than most people and so I'm guessing this rule does not apply to larger cities? It just doesn't make sense to me.

[LC]

I think it's a perfect rule of thumb. Our mortgage was about 80% of our take home pay, and we don't make a ton and we live in a nicer section of town (although not a major city). Those of you who say it is not possible to do this simply can't afford to buy, and should either move, make more money, or rent, as FMF has said. It's people who say there is nothing that they can afford and still proceed to buy a house that have cause the crisis we are in right now.

The make more money, rent, or move also doesn't make sense. We are obviously living in Seattle for a reason, due to family or job opportunities. It also doesn't make sense to just tell people to rent, as that is what most of us are trying to get out of. To make more money is not as easy as it sounds, as we both have thriving careers that take time to advance in. I am just confused how this is seen as being so simple?

[FMF]

Anon --

If you want to make excuses (we HAVE to live in this city, we HAVE to live in this size of house, we HAVE to do this or that) then you're right, you're going to have very few choices to make and very little opportunity to save/spend appropriately. If, on the other hand, you're willing to sacrifice a bit and make tradeoffs, this formula can work.

[SS]

The book does not say taking on a mortgage more than twice your salary is unreasonable, or immature, or irresponsible, or even that it is always possible in every situation while still getting a decent place. It just says that refraining from this is a big part of the path to becoming wealthy in a single generation. People who break this rule are not being judged in some way, other than to say the authors judgement that they will swim against the tide in an attempt to become wealthy.

I could probably not live and own a nice place (or any place?) in NYC and become wealthy on what I was offered to work there. But if there was a reason for me to live there that I considered more important than me becoming wealthy (and there are things more important than becoming wealthy) then I would move there. I would then have chosen a path that will likely prevent wealth but will have gained something else I think more important. I am happy I live in a country that I can make this choice (both the choice to live where I want to live and the choice to become wealthy, if I really want either bad enough).

I am currently choosing to work an extra job for a year and a half to be able to follow this rule (I am half way through it). Right now, this is worth it to me, next year (after I'm fed up with the job, missing my wife & kids, and have a huge lump of cash to put into a house) it probably will not be, and I will stop. Thank God most of us can chose to become more wealthy whenever we feel it important enough.

[Seattleite]

What's with all the "big house" accusations? As if that's the only thing that makes homes expensive? I always understood that price was based on location; size barely registers or matters to me.

I'm currently considering buying, and looking at small 1-bedroom condos. Anything within biking distance of my office isn't available for under $250K, and that's for older places that will probably need some renovation. Sure, I could move further away from work -- and then buy a car, and gas, and drive my polluting, expensive car to work every day. That doesn't sound like a worthwhile tradeoff to me, either.

I'm certainly not just whining that I can't have a 5-bedroom palace here. Also regarding rent, renting is not always a cheaper alternative. Rents are rising as landlords' mortgages rise.

(Oh wait -- maybe I should just go make some more money. I'll go talk to my boss.)

[FMF]

Seattleite --

You're right -- it's not necessarily the size of the house that's the issue -- it's the cost. People buying homes they can't afford, regardless of the size, is the issue.

Ya and live in the middle of nowhere and waste thousands on gas to get to work which is in the core of the city....BAD PLAN!

[agirlcandream]

To all of those people who say that everyone should just move to a low-cost-of-living area, what do you guys think is going to happen when all those big coastal towns are vacant?... And when all of us city slickers just up and move away in order to chase a lower mortgage, who is going to teach the kids, run the local governments, remove the trash, and put out the fires in those big cities? Big towns also need citizens at every socio-economic level, and they should all provide some affordable housing. Not everyone can move to the midwest or wherever else you guys are referring to. Another reason I'd like to stay put in my high-cost-of-living area is that's where my extended family is located; it might be expensive buying all those plane tickets to come back and visit my mom and grandmom. Just my two cents.

[brooklyn money]

Agreed with those who say this advice is not practical on the coasts. Even after the real estate crash. Except for marginal areas that are unsafe or less desirable which make them not a good investment, there's no way. I think people who don't live in a big city just really have no idea. And I am fiscally conservative and am considering buying in a marginal area, just so I can pay off the mortgage in a short amount of time (i don't have any kids so don't worry about school systems).

[Crystal]

Wow...this is the first article I've read on this site with so many posts that ring of entitlement and whininess. I wonder what happened to any of these people in the last 4 years who decided to buy anyway...

[EdC]

This advice has withstood the test of time. With the real estate bubble in hindsight, it's interesting to read the comments from people living on the coasts who said this advice could not be applied. We now know that the advice was not flawed. Rather, the real problem back then was that home prices were artificially inflated and unsustainable in relation to local wages.

[EdC]

@brooklyn money:
It's true that the big cities themselves are still too expensive. However, here in California, there are now plenty of affordable options within close commuting distance to the big cities. Many single family homes are now at prices that are cash flow neutral or even cash flow positive for an average income borrower. This would have been a pipe dream a few years back.

[Talon]

Wow, in hindsight one wonders how the folks who complained about how impossible this rule is did with their overextended debt to cover expensive homes which have lost massive amounts of value, 2008-2009 seems to be great evidence of the soundness of this rule.