Remember the 20% and 28% Rule When Buying a Home

Purchasing a home is not easy. Not only is it one of the most expensive purchases we will make in our lives, there are so many numbers to consider:

What is a good down payment?

How do I know if the monthly payment makes sense for our family?

In this post, I want to share with you two essential rules you want to consider when buying a home

 
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1) Down Payment - At Least 20% of Purchase Price:

The first rule of home buying is to only buy a home when you can afford a 20% down payment.

Many lenders will give you a mortgage even if you put less than 20% down. However, don’t think that they are being generous. Lenders are in the business of lending money so if they can lend you more money while mitigating their risk, they will eagerly do so. What’s worse is that they pass on all the risk to the borrower in the form of Private Mortgage Insurance, aka PMI.

Borrowers who can’t put down 20% are required to carry PMI on top of their mortgage. PMI typically cost between 0.5% to 1.0% of the entire loan amount. This means on a $300,000 mortgage if the PMI fee was 1.0%, borrower would be paying $3,000 annually or $250 monthly on top of his or her regular mortgage! Why!? By putting down 20% down payment, you can avoid this pesky PMI expense.

Some lenders might forgo the PMI fee even if you can’t put down a 20%. Why are they being so kind you might ask? Not so! Lenders want home buyers to borrow more money and they will do everything to make this possible. Stay strong and keep to the principle of putting down at least 20%. This rule will also make sure that you don’t buy more than you can afford. The 2008 housing crisis was a direct result of homebuyers buying more than they can afford by putting less than 20% down. Many mistakenly thought that just because the banks were willingly lending them the money, they could afford the payment.

2) Mortgage Payment - At Most, 28% of Gross Income:

The second rule of home buying is to ensure that the mortgage payment (including property taxes and insurance) is no more than 28% of your gross income.

28% is a general ‘mortgage rule of thumb’ used by lenders to assess borrowers ability to take on the mortgage. Lenders typically want no more than 28% of your gross income to go towards your housing expenses including mortgage payment, property taxes and insurance. If the debt-to-income ratio exceeds the 28% limit, borrower may not get the loan or need to pay a higher interest rate.

An example of this 28% rule looks as follows:

  • $500,000 home purchase

  • $100,000 down payment (20% down)

  • $400,000 30 year mortgage with 5.0% interest rate

  • $2,147 / month mortgage payment

  • $500 / month property tax ($6,000 a year)

  • $100 / month insurance ($1,200a year)

  • Your monthly mortgage plus property tax plus insurance would be $2,747 ($2,147 + $500 + $100)

  • Using the 28% rule, you would need to make around $9,800 a month ($2,747 = 28% of $9,800), or $117,600 annually to feel comfortable purchasing a home under the 28% rule

My recommendation is that 28% should be your upper most limit and you should aim to bring this number down as much as you can. Housing is most households biggest expense and is also the least flexible. You can quickly lower your monthly food or entertainment expense if need be. However, once you are locked into a 15 or 30 year mortgage payment it's not easy to get out of this obligation. Staying within the 28% rule will help you avoid the trap of buying a home more than you can afford.

Are you thinking about purchasing a home? Or did you recently become a homeowner? What do you think about these rules?