Wednesday, January 04, 2006

The 10% Down Rule

A friend of mine (let's call her Ms Jane Doe) wrote to me disagreeing with my 10% downpayment rule for buying a house. She argued that as a single mom, a 10% down was impractical, and would put people out of the benefits of home ownership forever. After some discussion with Jane, I realized her situation's a little atypical, and it actually meets several other rules-of-thumb I like to use. I'd like to discuss it here, because she actually has several things going for her that you should consider, even if you put 10% down.

  • Cost of the home I'd like to see mortgage payments no more than 25% of pretax income (ideally of one person's income - I'll explain why later). At present interest rates, that would work out to a house roughly 3.5 times gross income (preferrably one spouse's). While I don't know what Jane makes, her house appeared to satisfy this rule easily, and her mortgage payments were probably less than the 25% mark since she picked up her home when interest rates were lower.

  • Mortgage Payments In the event of a two-income family, I'd like to see a quarter of the second spouse's salary go to excess mortgage payments. In Jane's case, she indicated she's been paying extra on her mortgage (I think she mentioned double!), so she's quickly reducing her leverage, and thus protecting herself from the ill effects of debt.

  • Duration of ownership As I had pointed out in this earlier post, an analysis of housing data suggests that annual housing prices can fluctuate. If you are young and want the flexibility (or the need) to move around in search of work, a new home in a possibly overheated market is a bad idea. The risks reduce with time. Jane intends to live in her house for the rest of her life, a lot longer than even the 10-year time frame I analysed in my post.

  • Of course, all rules-of-thumb are just that. Your own situation may be different, so do your homework. If, for example, you have a kid, you also need to factor in tuition costs (which are increasing at 6-8% a year!). Or maybe you need to start a small nest egg not just for yourself, but for unforeseeable events - health issues, either for you or your parents or children, layoffs, disability, etc that may not be covered by your life, disability and health insurance.

    1 comment:

    Anonymous said...

    I didn't read your previous post, but don't forget about PMI, which is a big waste of your hard earned dollar. PMI protects the lender against default, not the borrower, yet the borrower must pay the premium! Generally, lenders require 20% down to get rid of PMI. However, some lenders will offer a 80/15 mortgage where the borrower pays only 5% down and actually has two mortgages, but gets rid of PMI. -Alex