I found this Kiplinger's "Truth or Bunk?" Quiz on Free Money Finance's site. I haven't even finished the quiz, but I ran into this question and it bugged me:
"True or false: Never buy a home that costs more than 2.5 times your annual income."
I knew they would consider the answer false, as it's become a somewhat outdated rule of thumb. Interest rates are lower than they used to be when this was widely used. But I answered "True" anyway. Here was the response:
SORRY, WRONG!
Your answer A. True is incorrect.
The right answer is B. False
Good luck even finding such a house in many major cities. Instead of the price, what counts is your monthly payment. And that's affected by your down payment and the terms of your loan.
I didn't add the emphasis. They bolded, "what counts is your monthly payment."
Seriously, isn't that how we got into this mess?
good observation. We all know the answer is true!
I honestly would not go to 2.5x my income.
If you do 2x your income, you can own a home AND be wealthy
Posted by: Moneymonk | January 15, 2008 at 12:37 PM
2.5 times is a stretch, unless you want to house poor. If you can finance 2 times or less you are setting yourself up for a nice financial future because you'll have remaining disposable income each month for investments.
Posted by: Frugal Dad | January 15, 2008 at 12:52 PM
It sure is how "we" got into this mess...
Posted by: Deborah | January 15, 2008 at 05:35 PM
WOO! When I bought my condo, the purchase price was about 3x my income. With my job change, it represents about 1.5x my income. I'm feeling smug. However, I'm also watching prices fall back to the original purchase price. Either way, I have a house I can afford.
Posted by: mapgirl | January 16, 2008 at 03:55 AM
They also had a question about ARM mortgages. They, of course, like ARMs because "Even when rates are rising, you can save a lot every month by going with an adjustable-rate mortgage -- if you plan to move before the rate changes." It's risky at best to base affordability on your ability to sell the house before the adjustment kicks in. If you really want to buy a house using an ARM, you should probably be able to afford that same house using a fixed-rate mortgage, too.
Posted by: Charles | January 17, 2008 at 03:20 AM
I suppose it follows some rule about mortgage payments not exceeding a certain percentage of income. It is a good rule as long as future wages and future mortgage payments are known. I guess in this case they weren't.
Posted by: Early Retirement Extreme | February 02, 2008 at 11:37 AM
Well keep in mind this is an advertisement. They want you to buy more house we can get in a bigger mess because until recently the banks were making buckets of money off people stretching to afford houses.
Posted by: Future Millionaire | February 13, 2008 at 01:40 PM
Great post - you're exactly right. A lot of people who bought houses over the last few years with a "payment they could afford" have found out that they really can't afford it when their adjustable rate mortgages adjust! That's exactly why we're in this housing mess.
Posted by: Larry Jones | February 19, 2008 at 11:10 AM
Great post - you're exactly right. A lot of people who bought houses over the last few years with a "payment they could afford" have found out that they really can't afford it when their adjustable rate mortgages adjust! That's exactly why we're in this housing mess.
Posted by: Larry Jones | February 19, 2008 at 11:11 AM
I am just curious, but where are you guys located? I live in LA County and the houses here are $500,000+. Based on the assumption of not buying a house that is more than 2.5x your income, I find that it is a bit hard to take in. Are you guys saying that you will advise me not to buy a house here unless I make at least $200,000 a year?
Posted by: Vince | February 26, 2008 at 09:57 AM
Vince,
No, I am not necessarily agreeing with the 2.5x income rule. It is outdated. The biggest reason that it is outdated is that interest rates are much lower than they were in the 70s when these rules were created.
The issue that I have with the way that the quiz worded the answer is the emphasis on "what counts is your monthly payment." We are now seeing the impact of people who could not afford homes buying with terms that they did feel that they could afford. That's the mess that I am talking about.
Posted by: LAMoneyGuy | February 26, 2008 at 11:43 AM
oh, okay. i see what you mean now.
I have another question to ask you, since you too live in california, "do you plan to buy a house here in the future? or move out of state like so many are considering?" T
PS: Love your blog!
Posted by: Vince | February 26, 2008 at 01:00 PM
Great to know that,
keep it up !
Tracy Ho
wisdomgettingloaded
Posted by: tracy ho | February 26, 2008 at 10:26 PM
In the San Francisco Bay Area, no one would be allowed to buy a house using those metrics. I have seen first time buyers taking down mortgages that are 4-5x their annual pay...and thinking that they got a great deal! What a way to completely impair yourself allowing for no ability to fund other financial goals. Let's hope the current comeuppance brings us back to some sense of balance...I mean REALITY for some people!
Posted by: Independent Financial Advice | May 17, 2008 at 10:09 PM
In the San Francisco Bay Area, no one would be allowed to buy a house using those metrics. I have seen first time buyers taking down mortgages that are 4-5x their annual pay...and thinking that they got a great deal! What a way to completely impair yourself allowing for no ability to fund other financial goals. Let's hope the current comeuppance brings us back to some sense of balance...I mean REALITY for some people!
Posted by: Independent Financial Advice | May 17, 2008 at 10:10 PM