Buying a house has been sold as a major part of the American Dream, but for many people, it doesn’t make sense for financial or lifestyle reasons. There are some good reasons to buy a house, but it’s important to examine your reasons before you make one of the biggest financial decisions of your life.
Here are 5 guidelines to help you decide if you’re ready to buy a house.
- Will you live there for 10+ years?
- Is your total monthly housing cost lower than 28% of your gross monthly income?
- Have you saved a 20% down payment?
- Are you OK if the value of your house goes down?
- Are you excited about buying?
Will you live there for 10+ years?
When you buy a house, a long time horizon matters because of the enormous fees involved in buying and selling a house. There are closing costs, taxes, furniture, realtor costs, and maintenance.
Closing costs for selling a house run around 10% of the house’s selling price. This means that if you sell your house for $300,000, closing could cost you $36,000 or more. And that’s just closing costs!
If you move in a short period of time — for example, four years — those fees will dwarf any equity gains you may have. Imagine driving a car off the lot: We all know that it instantly loses value. The same is true of your house, and it takes time to amortize (or spread) the costs over a long period of time.
Most people stay in their house for less than 8 years — and that number is actually higher than it’s been in several decades! Before the 2008 financial crisis, the average length of time that Americans stayed put was only around 4 years.
Don’t give in to the peer pressure to buy a house if you might not stay there for the long term. If you know that you want to move in fewer than 10 years, you will likely make more money by renting and investing in S&P index funds.
- Common mistake: “I’m not moving for a few years. I should buy so I don’t throw money away on rent!”
- Reality: If you buy for a short period of time, when you factor in all costs, you will almost certainly lose money.
Is your total monthly housing cost lower than 28% of your gross monthly income?
Your total housing costs should be less than 28% of your gross income. When housing costs exceed 28%, you run the risk of being overwhelmed with expenses if something goes wrong (e.g., an unexpected repair, job loss, etc). Use the 28/36 Rule to see if you can afford your housing.
Here’s an example:
- Assume you make $10,000/month gross (that’s $120,000 per year gross, or before taxes).
- Assume your total housing costs are $2,000 per month. Great! Your housing costs you 20% of your gross income. You pass this test and you can afford your housing.
- Note that total housing costs include everything: taxes, interest, maintenance, furniture, electricity, water, even the roof repair 7 years from now (project it).
Why gross income? I use gross because it’s easy to calculate. Everyone knows their gross income and taxes complicate net income (different people choose different deductions). However, if you prefer to use net income, go for it! I love hearing when people create their own point of view on their finances.
Exceptions to the 28/36 rule
- If you live in a HCOL (high cost-of-living) area like NYC or Los Angeles, many people stretch the 28% number to 35% or even 40%.
- If you have no debt (e.g., no car payment, student loans, or credit card debt), you might stretch the numbers a little. I’d consider going to around 33%, but I’m conservative with my finances.
- If your income is reasonably expected to go up soon, such as a job promotion, you may stretch the numbers a little. Again, I’d conservatively consider going to 33%…maybe.
Have you saved a 20% down payment?
If you haven’t saved a 20% down payment, you’re not ready to buy a house.
Why? Not just because of PMI, which is an additional fee you’ll often pay when you get a mortgage without 20% down.
The real reason to save 20% before buying is counterintuitive: Building the habit of saving is critical before you buy and have unexpected housing expenses such as a broken water heater, roof, or unexpected taxes.
I frequently get frustrated comments about how “impractical” this rule is. “How am I supposed to save 20%? That will take years!”
Yes, it will. Which is exactly why you should save now. Saving is a habit, which is better practiced before your mortgage is at risk.
If you write a comment like this, you are not ready to buy a house
Note: I don’t mean that you have to put 20% down. In some cases, such as low interest rates, many people intentionally choose to put a small amount down. But you should be able to.
Are you OK if the value of your house goes down?
If you are buying because you believe the price of a house always goes up, reconsider: Real estate is not always the best investment.
Here are some good reasons to buy a house
- You have kids and you want to stay in your area, school district, and build memories in the same house for at least 10 years
- Your parents are moving in with you
- You want to design a house together with your spouse
- You love repairing and tinkering with a house and making it your own
- You just want to!
Notice what’s not on the list: “You need the price of the house to go up.” Maybe it will — if so, great! Maybe, once you factor in expenses and opportunity cost, you could have gotten a much better return in a simple S&P index fund.
Buy for the right reasons.
Are you excited about buying?
If you’re approaching buying a house with dread — like a heavy feeling of obligation or peer pressure — just stop. You don’t need to buy and you should never feel guilty for renting. I rent by choice.
If you’re truly excited about buying, then you might be ready to buy.
Final thoughts on these rules
You don’t need to follow any of these rules. Your money is yours.
In fact, I’m sure you can point to someone who bought a house with 3% down and did fine.
But you’ll rarely hear from people who made disastrous housing decisions. They simply disappear, never to admit their mistakes. Many times, they don’t even know why they got into trouble.
I hear from hundreds of them every month. And I can tell you that these rules will keep you out of the biggest sources of financial trouble for people who buy a house.
These are conservative rules that will keep you out of trouble. Yes, they might take you more time to buy. And yes, you might see people seemingly “skip the line” and buy a house before you.
But for the biggest purchase of your life, I believe you should be conservative. Take your time — there’s no rush. Most of the time, when you hear people in a big rush to buy, it’s not a careful consideration of facts — it’s fear that they’ll be “priced out” or an emotional rush from seeing headlines of houses selling for way more than they can afford.
Many people who end up in financial trouble skip these rules. Don’t be one of them.