Free Money Finance Top 10 Most Hated Posts/Themes: #5 My Formula for Buying a House

Ooooooooooooo! Now I'm getting into your biz-ness!!!!!! ;-)

If you've been reading Free Money Finance for any amount of time, you've probably seen My Formula for Buying a House. This formula is based on my experience buying and selling houses for 20 years. This is what's worked for me and hence it's what I recommend to others.

But people hate this formula. Specifically, they hate two parts of it:

1. Live in (or move to) a cheaper area of the country. This topic is a real argument-starter and thus deserves its own place in our top ten list. Stay tuned to future posts in this series where I'll talk about it more in-depth.

2. Buy a house you can easily afford. Here's what people hate about this advice:

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.

As soon as I say that I get "that can never be done," "this is impossible in my area," and on and on.

A couple thoughts on this:

1. This is what's worked for me -- I've done it. I assure you, it can be done, so don't say it can't. No, it probably can't be done on a 3,000 square-foot home on a golf course in New York, but that's just the point -- if your income's not high enough, you shouldn't be buying a place like this.

2. Note that it says that the MORTGAGE shouldn't be more than twice your household's income, not the VALUE of the house. Maybe it means you need to save more up front as a downpayment to get to the point where your mortgage is low enough to meet the criteria.

I think this is good advice and if followed, it will help you grow your net worth. That said, people still don't like my formula and hence it makes #5 on my most hated list.

Comments

[Jeremy]

I think both of those topics are fantastic pieces of advice. Unfortunately, like some of the responses you've seen from that advice, the younger people who are buying homes right now are stretching themselves much farther than they should. I think a lot of it comes with the instant gratification mindset of many people today. People are so focused on there here and now, they will sacrifice almost anything to get what they want without thinking about the long-term effects... take that attitude with the banks willing to offer you almost any type of financing to make it possible, and you find yourself in a situation that could be less than optimal.

I know when we were purchasing a house about a year ago I had to overcome this with my wife (and the bank). She is the spender, I'm the saver. So every house we looked at, everything had to be perfect. It was impossible, she wanted so many specific things, and then the bank had us pre-approved for an insane amount of money that could have purchased the house of our dreams, but we'd spend the next 10 years dumping all of our money into a mortgage payment letting things like retirement savings be brushed aside.

Thankfully we were able to come to a compromise, we looked into a more rural area where housing was far cheaper, and we started looking at homes almost half of what the bank was willing to lend us. We ended up finding a great house with most of the things we needed, could use some slight updating in some rooms, yet close enough to our employers. Now we are building equity faster than we ever could have with the other housing options, we're both putting away much more towards savings and paying down debt, and now our next home can be that much better.

It is a shame though, I see some of my friends buying brand new houses in new subdivisions, just able to make payments. Sure they have beautiful new homes, but at 30 with no kids, who needs a 4 bedroom home with a finished basement, 2 car garage and a golf club membership? It would be nice to have, but why have a life that involves working 50 hours a week for the sole purpose of having a $2500 mortgage payment?

[Catherine]

I have been reading your blog for quite some time (over a year) and totally agrees with you on your house buying formula. Actually I (try my best to) follow a formula put out by a financial consultant named Charles Farrell:

http://www.fpanet.org/journal/articles/2006_Issues/jfp0106-art6.cfm

According to him, your debt-to-income ratio should not even be more than 1.70. 1.70 when you are 30 and 1.50 when you are 35, and decreases to 0 when you are 65.

I bought a house four and a half years ago in a lower cost city (Atlanta) with 20% down. It actually is a 3000+ square-foot home but very reasonally priced. I pay extra into the mortgage every month and will have the entire balance payed off in about 8 years. At the same time, I make the maximum contribution into both my 401K and Roth IRA, and save 10% of my salary. This is possible all because of the (much, comparing to certain parts of the country) lower mortgage payment.

Thanks a lot for posting all the great ideas and keep up the good work.

[Lord]

The reason you have to pay more than this in metropolitan areas is that ownership in these areas is the best investment you can make, better than equities even. It is no coincidence that people stretch themselves so far in these areas. That is not something you can say elsewhere where leverage is at best neutral. That said, there are times to buy and times not to and while one should stretch oneself somewhat, too many overstretch themselves and too many only concern themselves with the initial payment. If it is not time to buy then save towards a larger downpayment. Buy a home that you can be happy in and can keep for some time. Just as newer doesn't mean better, larger doesn't either. That said when I first bought, my mortgage was 3 times my income and I still had it paid off in 12 years.

[Foobarista]

Frankly, I have done well (net worth about $850K, with about 2/3 not in residential real-estate) by ignoring this advice and living in Silicon Valley. My mortgages were about 2.5x my gross at the time, although rapid salary growth allowed me to quickly get to where the mortgage was much less.

I certainly wasn't buying country-club homes - my first place was an 800 square foot condo, my current place is a 1400 square foot townhouse on a 3500 square foot lot - but the high salaries in the area made it worthwhile to stay put. My mortgage balance is now about 1.1x my salary, and our cash&investment net worth will grow by about $130K this year.

Frankly, we've looked at other parts of the country, and while they are amazingly cheap by SV standards, there's no work in my field, and a large and active Chinese business and social community keeps my wife happy. And we can go hiking year-round and can fly to China in less than 12 hours.

[Lazy Man and Money]

I think I'd give some room to 2.5x your income depending on the part of the country. My first condo was 4x my income and I had no problem making the mortgage payments and saving some money as well. The place wasn't exactly a castle, just a two bedroom, less than 1000 sq. ft. place. It suited me well and I'd do it again.

I like your rule as long as when the math is done, you can buy something in the bottom area of the market.

[Foobarista]

One other crucial point that is implicit in these assumptions: when do you get married? Many people - me, for example - bought their first property before they get married, and got married later to a spouse who earned a similar income. I'd probably not want a loan that was 2.5x our combined income - or even 2x - but 2.5x one of our incomes would work.

In many ways, this is why I don't like "rules of thumb". There are lots of thumbs!

[dimes]

Honestly, people will buy for whatever the bank will lend them. When we were mortgage shopping two years ago, we ran some numbers and figured out what we could afford, but lenders were beating down our door trying to give us 150% of the maximum that we could afford. Ultimately we opted not to buy, which is good, because real estate values in this area are beginning to plummet. But seriously, until this practice is stopped, people won't quit buying beyond their means.