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How To Buy A House Without Going Broke (Rule of 200)

It's one of the biggest financial decisions you'll ever make and quite frankly it's one that not even the experts can agree on. Deciding whether to rent or buy can have a massive impact on your financial success and your life as a whole. As it currently stands, many people have been indoctrinated to believe that one of the true signs of success is owning your home and that renting is equivalent to throwing your money into the trash. I believe that over the last few years people have begun to realize that renting offers numerous benefits; many of which have gone unnoticed up until now. Because of this, the debate of whether or not it's better to rent or buy has never been more contentious. In fact there are many different reasons why people would choose to rent or choose to buy and in this article I'm going to share with you the hard numbers of whether or not you can afford to do one over the other.

Before we get into the number crunching, I want to go over the benefits of both renting and buying so that I don't appear to be biased towards either of these two viable options. You see, I grew up like many people having my parents tell me that renting is throwing your money away and that you'd be much better off paying down your own mortgage than the mortgage of your landlord. For the short period of time where I was renting I actually did feel as if I was throwing money away but I'm not blind to the fact that renting offers many benefits and while for many renting may not be the popular choice, it makes sense for a ton of people.

For instance, renting offers you maximum living flexibility. If you're someone that likes to city hop every few years or wants to try living in different neighborhoods in the city that you love then this is a lot more easily done being a renter than if you were to own a home. Not to mention, when you rent costs are typically less than if you were to own a home given that you're not paying routine expenses like property tax. Moreover, if something breaks in the place you’re renting, you can simply call up your landlord and get them to deal with it rather then having to fix it yourself. Finally, one of the biggest benefits is that you don't have to save up for down payment before moving into a new place. All you have to do is sign a lease agreement and soon enough you'll be enjoying your new accommodations.

As you can see there are many benefits to renting but there are equally as many benefits to being a homeowner. First of all, when you own a home and you're making mortgage payments you're building equity in that home. Building this equity will increase your net worth and can be leveraged to make further investments if you decide to pull out some of the cash you’ve invested in your home. Not to mention, owning a home offers you pride of ownership and the ability to alter and design your home as you please which is rarely the case when you rent. Also, as the housing market increases in value so will the asset that you possess therefore you can also see financial gains by owning a home. Finally, by owning, you've extinguished any risk you would have of being evicted which offers you more housing stability and this is an element of homeownership that many people overlook but that has quite a bit of value in and of itself.

Even after going through the benefits of renting, if you still feel like buying is a better option for you then that's great but there's a difference between wanting to do something and actually being able to afford to do it and this is where the Rule of 200 comes into play. (Shoutout to MoneyInYourTea for creating this fantastic concept)

The Rule of 200 is a financial model used to determine the price of a home you can afford and the calculation to derive this figure is as follows:

Home value = (200 x Current Monthly Rent) + Down Payment Funds – Cost of Private Mortgage Insurance

This financial model operates under the following assumptions:

  • You’re taking on a 25-year mortgage

  • Your mortgage is carrying a 3.5% interest rate

  • Your current monthly rent does not include utilities or insurance

By working within these assumptions, the home value that you will calculate will have your mortgage payment equaling your current rent payment.

Here’s a worked out example of the rule of 200:

Monthly Rent: $2,500

Down payment $30,000

PMI: $0

Home value = (200 x $2,500) + $30,000 - $0= $530,000

One thing to keep in mind when performing this calculation is that the rent you are entering into this formula should be a rent amount that you can actually afford. If you are currently paying an amount of rent that is making you drown in debt, then clearly this figure will not work for the purpose of calculating a home’s price and subsequently a mortgage payment you can afford. If you don't know what a reasonable amount of rent is, I’m happy to inform you that there's a very easy rule of thumb you can use to calculate this figure. The rule of 40X (yes…another rule to follow) suggests that your rent should be no more than your gross annual income divided by 40. For example, if you make $80,000 a year then you should be spending no more than $2,000 a month on rent.

Now let's face it, not everyone has the money or desire to buy a freehold property which means that they might opt to pursue the purchase of a condo instead. If you're in this situation then you must tweak the Rule of 200 slightly before performing this exercise. Prior to inputting your rent figure into the formula, you must subtract what your anticipated monthly condo fees would be as this will be another expense you will bare as a home owner and this will reduce the total value of the home you can afford.

Here’s a worked out example of the rule of 200 when buying a condo:

Monthly Rent: $2,000

Down payment $30,000

PMI: $5,000

Condo Fees: $500

Home value = [ 200 x ($2,500 - 500) + $30,000 - $5,000 ] = $425,000

As you can see, with the same current rent payment but the incorporation of condo fees, the amount of home you can afford will vary significantly.

Once you perform this calculation you're ready to go buy a home right? While this formula is a great starting point, I recommend that you take this exercise one step further by assessing how much house you can afford if interest rates were to change. As you would expect, mortgage interest rates are inversely related to the multiplication factor that you would use in this exercise. Simply put, the greater the interest rate used in this calculation, the lower the multiplication factor will be turning the rule of 200 into the role of 190 or 170 or whatever other factor you want to use based on the interest rates you are anticipating to experience. Here is a list of some stated interest rates and their multiplication factors.

Here’s a chart you can consult when doing this exercise for yourself:

Now that you've run your home buying equation through a couple of different iterations, you're ready to move into that new home of yours right? Well, before you do, I want to go over a couple of the flaws of the rule of 200 but before I do I think it’s worth reviewing some other cost considerations that come with home ownership first.

Unfortunately, the Rule of 200, as it presently stands, does not take into account certain upfront fees that are commonly associated with buying a home. Costs such as paying for a home inspection, lawyer fees, land transfer taxes, moving costs and buying furniture for the home are not taken into account when performing this exercise. And let me tell you from my own personal experience that these costs can actually equate to more than your down payment therefore they definitely aren't costs that you can just glaze over. Not to mention, you will have other monthly costs that you will need to bare as a homeowner such as property taxes, repairs and of course paying for home insurance.

Beyond these cost considerations, I think that the Rule of 200 has another weakness in the fact that it can’t be applied reliably in every housing market. The fact of the matter is that the Rule of 200 simply will not work if you are buying a home in a city that has a very high cost of living. Let's use expensive real estate in New York City's Upper West Side as an example.

Here are the core financials:

Monthly Rent: $5,000

Down payment: $300,000

PMI: $0

Home value = (200 x $5000) + $300,000 - $0= $1,300,000

As you can see in the example above, if you're currently paying $5,000 a month in rent and are able to amass $300,000 as a down payment then you could afford to buy a home worth $1.3 million dollars assuming that the interest rate would be 3.5% on your mortgage. The rent figure used in the example above is for a standard 2 bedroom apartment in this upscale area of Manhattan. Unfortunately, if you were to investigate a little bit further you would come to realize very quickly that a property of this size in this part of town easily eclipses $1.5 million which means that based on the Rule of 200, you couldn't actually afford to buy the home that you're renting. This phenomenon takes place in many high cost of living cities around the world and is a reason why many people are relegated to renting because the barrier of buying is simply too high. Keep in mind that this calculation is not incorporating the risk of an increase in interest rates which would put this property even further out of reach.

Moving on, even with the Rule of 200 being effective in most parts of the world, people still may not gain value from this formula however it’s not to the fault of this financial model. In fact, it has everything to do people’s own buying behaviors.

As someone who has bought a home and has many friends who have bought or are currently buying homes, I know the temptations that arise when going through this process. You are in a constant struggle to balance your expectations against your budget and in many cases people will begin to veer away from their budget in order to move into that dream home that they've always wanted. It's not uncommon to see people sidestep this rule in order to buy a home that they can't afford. I believe people do this for two primary reasons. The first reason is that they simply have no idea how much house they can actually afford because they never go through the exercise of employing the Rule of 200. Alternatively, other home buyers may know exactly how much they can afford to spend on a new home but simply disregard this amount. They do so because the home that they can afford with this amount of money doesn't meet their expectations of what their home should look like. These expectations usually stem from their personal sense of entitlement or pressure from those around them to have the best home on the block. Either way, by straying away from this reliable financial model, you're destined to face some degree of house poverty after signing the purchase agreement on a budget busting home.

Sadly, I can't intervene in every single person's home buying experience. What I can do in this article is offer a little bit of advice on how I would employ the Rule of 200 for someone who wants to make a responsible home buying decision.

The first thing I would do when performing this calculation is to take off 10 points from the multiplier right off the bat. Effectively, I would turn the Rule of 200 into the rule of 190. As I've explained earlier in this article, the lower the multiplier, the lesser the value of the home that you are going to buy and generally speaking I feel that taking a more conservative approach when it comes to buying a home will grant you more financial leeway in your day-to-day life. Reducing the amount of financial housing burden you take on will allow you to save and invest more money and also not feel an immense amount of financial pressure that your mortgage may place upon you. Not to mention, by lowering this multiplier you will naturally be taking into account some variability in your mortgage’s interest rate.

Beyond the financials, I have to drive home the point that you should be buying a home that you want and can afford and not what someone else wants for you. If you're buying a home to appease other people then I think that you should reconsider buying a home altogether.

Now some people may argue that buying a bigger home is a good investment because this home will only become more expensive in time and I don't necessarily disagree with this argument. While this could be someone just trying to justify overextending themselves when buying a home, even if it is I want to share a strategy that you can use in the event that you need tip bust the Rule of 200.

This is where I make a slight alteration to the Rule of 200 by incorporating what I call the rental factor. You see, one way to be able to afford to buy a bigger home is to use part of the home to earn you the income that will offset a mortgage or housing cost that you may not be able to afford. Here is how the math shakes down:

Home value = [200 x (current monthly rent + anticipated rental income) + down payment - PMI

By adding into the equation the amount of rental income that you anticipate to make from owning this home on a monthly basis you will be effectively increasing the total home value that you can afford. However, there are two things you should keep in mind after performing this calculation. The first is that even if you think you can offset part of the housing costs by renting out part of your house, you may not actually be granted a large enough mortgage from the bank to be able to afford such an expensive home. Not to mention if you are buying a home with the intention of renting part of it out, there's always the risk that the anticipated rental space will remain vacant for periods of time which will then put more financial pressure on you to meet your mortgage obligations. This is why I think it makes more sense to be conservative when buying a home by relying upon the Rule of 190 when making this large financial decision.

In summation, the Rule of 200 is not a perfect solution but it does act as a very reasonable guide when assessing how much home you can afford. Therefore, if you're currently on your own home buying journey, I strongly recommend that you play around with the numbers so that you can make the most educated decision possible.

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