Net-worth rule of thumb for house purchase?

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rbaldini
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Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 2:32 pm

We get questions all the time about whether one should and could purchase a house of some price. There are general rules of thumb as regards PITI relative to income - e.g. recurring housing expenses shouldn't exceed x% of income, or that that total debt payments shouldn't exceed y% of income, etc.

But I don't know of any rules of thumb regarding net worth - e.g. don't buy a house whose value exceeds some factor of your net worth. One could imagine all sorts of formulas. Maybe those are around and I've just forgotten about them.

Here's a simple rule I came up with. It is based on the following scenario: suppose you purchased a home, and very quickly thereafter the price of the home declined by some realistic x%, *and* you suddenly needed to sell the house (perhaps your income has dropped indefinitely such that you can no longer afford the recurring payments). The primary risk with purchasing a house, as compared to renting, is that you are most likely taking on quite a bit of debt, commonly 80% of the house's sale price. If you want to be able to pay that debt off at the time of sale, your liquid assets need to be large enough to make that payment.

To a first order approximation, you have liquid assets of $L prior to the purchase. After the purchase, you paid $P*d (where P is home price paid, and d is proportion down payment) of your liquid assets to the lender. The house then drops to a value $P*(1-x), which you recoup on the sale. You now need to pay the remaining amount on the loan, approximately $P*(1-d).

To be able to afford this, you need L - P*d + P*(1-x) > P*(1-d). Or

L > x*P

In other words, you should only buy a house if you have enough liquid assets to draw on to pay for a pessimistic dip in house price of x%. It's up to you what to use for x. If we imagine a worst-case scenario to be something like a house price drop of 50%, then the rule is that you should have liquid assets in excess of half of the home's price. If you want to buy a $500k house, you should be able to, right now, come up with $250k cash if you had to. What counts as liquid is somewhat subjective. For example, you could withdraw contributions from a Roth IRA if necessary, but you might not want to factor that in, given the opportunity cost of doing so.

Obviously this smooths over a lot of complications - hence, rule of thumb. It ignores the transaction costs of buying and selling; that some of the debt will have already been paid off; that your liquid assets are not fixed, and while they hopefully grow during your home ownership tenure, they may decrease for the same reason that the house price decreases; that this might happen 5 or 10 years down the line instead of almost immediately. But it seems like a decent starting point.

I have never actually sold a house before (bought our first two years ago), so I may be making some fundamentally flawed assumptions. Let me know. Thoughts?

tesuzuki2002
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Re: Net-worth rule of thumb for house purchase?

Post by tesuzuki2002 » Wed Aug 14, 2019 6:53 pm

That was/is a long post. 50% liquid cash is a good margin that reduces risk.

Why not just pay cash for the home?? Then if you need to get out of it due to life changes you''ll eventually leave with cash in your pocket.

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nps
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Re: Net-worth rule of thumb for house purchase?

Post by nps » Wed Aug 14, 2019 6:58 pm

rbaldini wrote:
Wed Aug 14, 2019 2:32 pm
But I don't know of any rules of thumb regarding net worth - e.g. don't buy a house whose value exceeds some factor of your net worth.
Ask KlangFool

stan1
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Re: Net-worth rule of thumb for house purchase?

Post by stan1 » Wed Aug 14, 2019 7:16 pm

Rules of thumb apply to a generic non specific person. Rules of thumb may or may not apply to an individual's circumstances. Better to look at your specific situation than to seek a false sense of comfort with an equation or formula that doesn't give you an answer specific to your needs.

megabad
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Re: Net-worth rule of thumb for house purchase?

Post by megabad » Wed Aug 14, 2019 7:18 pm

I assume we are talking about a primary residence. If so, I would ask why your current networth would matter at all for a housing purchase. Who cares how much your house costs in terms of networth? I only care how that purchase affects my lifestyle. If my house is 99% of my networth and I have $1 billion, I probably wouldn't have a care in the world (not sure how much prop taxes would be though :happy ). To test my philosophy, what happens when mortgage interest rates go to 15% in your formula above? I hope the formula changes because I would hope you would buy less house. It would be much easier to come up with a useful rule of thumb using expenses.

DoctorPhysics
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Re: Net-worth rule of thumb for house purchase?

Post by DoctorPhysics » Wed Aug 14, 2019 7:25 pm

Banks will figure out a LTV for you and approve a loan amount. Take 10-20% (or more) off that amount so you have cash flow to handle things. Don’t max out the loan because you can.

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 7:31 pm

tesuzuki2002 wrote:
Wed Aug 14, 2019 6:53 pm
Why not just pay cash for the home?? Then if you need to get out of it due to life changes you''ll eventually leave with cash in your pocket.
The personally wouldn't do that. That's a lot of money that could be invested in the stock market, which I believe tends to return more than just price appreciation on a residential home.

The point isn't about how much to put down (that variable, d, dropped out of the inequality). It's about how much liquidity you should have available prior to the purchase.

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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Wed Aug 14, 2019 7:36 pm

OP,

The net worth excluding the house should be 2.5 times or greater than the house's price. For example, if you want to buy a 400K house, your net worth excluding the house should be 1 million. The net worth should be after you pay the 20% down payment. In this case, the exact number would be 1.08 million or greater.

KlangFool
Last edited by KlangFool on Wed Aug 14, 2019 7:38 pm, edited 1 time in total.

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 7:37 pm

megabad wrote:
Wed Aug 14, 2019 7:18 pm
I assume we are talking about a primary residence. If so, I would ask why your current networth would matter at all for a housing purchase. Who cares how much your house costs in terms of networth? I only care how that purchase affects my lifestyle. If my house is 99% of my networth and I have $1 billion, I probably wouldn't have a care in the world (not sure how much prop taxes would be though :happy ). To test my philosophy, what happens when mortgage interest rates go to 15% in your formula above? I hope the formula changes because I would hope you would buy less house. It would be much easier to come up with a useful rule of thumb using expenses.
I think it's pretty common sense that, holding income constant, a person with lesser net worth should be more cautious about buying a house. Hopefully my logic was clear above. If the house loses a substantial amount of money by the time the owner wants or needs to sell, they may need to rely on more than the proceeds of the house to pay their mortgage debt. A person with more money can do so more easily, and so is less at risk. The idea was to try to quantify, in a very simple (maybe too simple) manner, the relationship between liquid assets and house price.

Of course you are right that other variables matter. I was aiming for something like the "one shouldn't buy if PITI exceeds x% of income". That too is extremely oversimplified and leaves out many variables... but it's still useful. I'd think that one could combine many simple rules of thumb and make decisions accordingly.

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 7:38 pm

KlangFool wrote:
Wed Aug 14, 2019 7:36 pm
OP,

The net worth excluding the house should be 2.5 times or greater than the house's price.

KlangFool
Thanks for sharing. I know you are quite conservative when it comes to home ownership. I don't agree, but to each his own. :sharebeer

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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Wed Aug 14, 2019 7:40 pm

rbaldini wrote:
Wed Aug 14, 2019 7:38 pm
KlangFool wrote:
Wed Aug 14, 2019 7:36 pm
OP,

The net worth excluding the house should be 2.5 times or greater than the house's price.

KlangFool
Thanks for sharing. I know you are quite conservative when it comes to home ownership. I don't agree, but to each his own. :sharebeer
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool

tesuzuki2002
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Re: Net-worth rule of thumb for house purchase?

Post by tesuzuki2002 » Wed Aug 14, 2019 7:46 pm

rbaldini wrote:
Wed Aug 14, 2019 7:31 pm
tesuzuki2002 wrote:
Wed Aug 14, 2019 6:53 pm
Why not just pay cash for the home?? Then if you need to get out of it due to life changes you''ll eventually leave with cash in your pocket.
The personally wouldn't do that. That's a lot of money that could be invested in the stock market, which I believe tends to return more than just price appreciation on a residential home.

The point isn't about how much to put down (that variable, d, dropped out of the inequality). It's about how much liquidity you should have available prior to the purchase.

I agree that putting that money down on a home isn't for everyone. I like to be definitive on some purchases and just simply move on with life. Price appreciation in real estate has historically been higher than the S&P500 so you pick and choose where to earn your gains.

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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 7:49 pm

KlangFool wrote:
Wed Aug 14, 2019 7:40 pm
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool
Not following. Suppose I have $250k. I buy a $100k house outright (so net worth > 2.5x house), leaving me with $150k in stock. The stock market loses 50%, so I now have $75k in stock and still $100k in the house, so I have $175k. There is no mortgage left to pay off, so I have $75k in liquidity and $100k in house, which I can make back when I sell. That's well more than enough than is needed to move elsewhere. Seems to me your conservative rule would only require than my net worth exceeds the house value (prior to the house purchase). Are you considering ahouse price drop too?

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Re: Net-worth rule of thumb for house purchase?

Post by JohnFiscal » Wed Aug 14, 2019 7:52 pm

For what it's worth, I had the same question recently...being as I am now retired and do not expect any more "salary income" in order to plug into one of the handy rules of thumb. In my case, I was contemplating what % of my current net worth is it advisable to (potentially) spend on a new home, in a new area. There were some related existing discussions on the BH forum but as I was anticipating (potentially) buying a home in Canada I posted at the related "BH North" forum, Financialwisdom.

See discussion here, it may provide some useful insights (thanks to my Canadian friends for their comments) https://www.financialwisdomforum.org/fo ... 9&t=122028

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Re: Net-worth rule of thumb for house purchase?

Post by megabad » Wed Aug 14, 2019 7:52 pm

rbaldini wrote:
Wed Aug 14, 2019 7:37 pm
I think it's pretty common sense that, holding income constant, a person with lesser net worth should be more cautious about buying a house. Hopefully my logic was clear above. If the house loses a substantial amount of money by the time the owner wants or needs to sell, they may need to rely on more than the proceeds of the house to pay their mortgage debt. A person with more money can do so more easily, and so is less at risk. The idea was to try to quantify, in a very simple (maybe too simple) manner, the relationship between liquid assets and house price.

Of course you are right that other variables matter. I was aiming for something like the "one shouldn't buy if PITI exceeds x% of income". That too is extremely oversimplified and leaves out many variables... but it's still useful. I'd think that one could combine many simple rules of thumb and make decisions accordingly.
I agree that the PITI as a % of income method is not perfect, but it is more easily used and encompasses more variables than just the predicted house sale price (which to me is the hardest variable to know). Of course, one could easily argue that maybe both fall apart if you don't have a mortgage. I would think a networth formula would have to include at least interest rate, tax rate, and age in some capacity to be able to be representative for a big sample of folks. This makes a networth formula quite a bit more complicated that the % PITI method.

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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Wed Aug 14, 2019 7:55 pm

rbaldini wrote:
Wed Aug 14, 2019 7:49 pm
KlangFool wrote:
Wed Aug 14, 2019 7:40 pm
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool
Not following. Suppose I have $250k. I buy a $100k house outright (so net worth > 2.5x house), leaving me with $150k in stock. The stock market loses 50%, so I now have $75k in stock and still $100k in the house, so I have $175k. There is no mortgage left to pay off, so I have $75k in liquidity and $100k in house, which I can make back when I sell. That's well more than enough than is needed to move elsewhere. Seems to me your conservative rule would only require than my net worth exceeds the house value (prior to the house purchase). Are you considering ahouse price drop too?
rbaldini,

As per your example, you need 350K. After buying the house, you only have 150K = 1.5 times. I do not care about the house value. Only the house price when you choose to buy. I assume that the house could drop to zero.

KlangFool

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 8:24 pm

KlangFool wrote:
Wed Aug 14, 2019 7:55 pm

rbaldini,

As per your example, you need 350K. After buying the house, you only have 150K = 1.5 times. I do not care about the house value. Only the house price when you choose to buy. I assume that the house could drop to zero.

KlangFool
Ah, you’re assuming 50% drop in stocks and complete loss of house value. Too conservative for me, but fine if that’s your thing.

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 8:26 pm

tesuzuki2002 wrote:
Wed Aug 14, 2019 7:46 pm
I agree that putting that money down on a home isn't for everyone. I like to be definitive on some purchases and just simply move on with life. Price appreciation in real estate has historically been higher than the S&P500 so you pick and choose where to earn your gains.
Price appreciation of real estate alone, without renting out the property or doing something productive with it, historically beats S&P 500 gains?

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Wed Aug 14, 2019 8:29 pm

megabad wrote:
Wed Aug 14, 2019 7:52 pm
I agree that the PITI as a % of income method is not perfect, but it is more easily used and encompasses more variables than just the predicted house sale price (which to me is the hardest variable to know). Of course, one could easily argue that maybe both fall apart if you don't have a mortgage. I would think a networth formula would have to include at least interest rate, tax rate, and age in some capacity to be able to be representative for a big sample of folks. This makes a networth formula quite a bit more complicated that the % PITI method.
It's not so much that we are predicting the end sale price at which you move out. It's more that we are considering a worst-case scenario of something like 50% loss (of course it could be more than that, but, eh, you pick something reasonable; you're free to disagree). People do stuff like this all the time: "don't invest in stock unless you can afford to lose 50% of it", etc. Then under the simple assumptions I said, you'd want your liquid assets at the time of purchase to be at least 1/2 the price of the house. E.g. if you are looking for a house, and only have access to $200k right, you should budget for nothing more than a $400k house, at this point.

An even more conservative approach would be to assume that *both* the house and the liquid assets depreciate by 50%, in which case the rule is simply not to buy anything that exceeds your liquid net worth. That's probably too conservative for most.

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Re: Net-worth rule of thumb for house purchase?

Post by BogleMelon » Wed Aug 14, 2019 9:26 pm

KlangFool wrote:
Wed Aug 14, 2019 7:40 pm
rbaldini wrote:
Wed Aug 14, 2019 7:38 pm
KlangFool wrote:
Wed Aug 14, 2019 7:36 pm
OP,

The net worth excluding the house should be 2.5 times or greater than the house's price.

KlangFool
Thanks for sharing. I know you are quite conservative when it comes to home ownership. I don't agree, but to each his own. :sharebeer
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool
What if someone has most of his net worth in bonds? Would the 2.5 times rule change to a lower number since he wouldn't have to deal with 50% loss probability? In other words, should that rule of thumb be linked to one's AA, so that the less stocks ratio, the lower the net worth needed to buy the house?
Last edited by BogleMelon on Thu Aug 15, 2019 6:06 am, edited 1 time in total.
"One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

KlangFool
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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Wed Aug 14, 2019 9:32 pm

BogleMelon wrote:
Wed Aug 14, 2019 9:26 pm
KlangFool wrote:
Wed Aug 14, 2019 7:40 pm
rbaldini wrote:
Wed Aug 14, 2019 7:38 pm
KlangFool wrote:
Wed Aug 14, 2019 7:36 pm
OP,

The net worth excluding the house should be 2.5 times or greater than the house's price.

KlangFool
Thanks for sharing. I know you are quite conservative when it comes to home ownership. I don't agree, but to each his own. :sharebeer
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool
What if someone has most of his net worth in bonds? Would the 2.5 times rule change to a lower number since he wouldn't have to deal with 50% loss probability? In other words, should that rule of thumb be linked to one's AA, so that the less stocks ration, the lower the net worth needed to buy the house?
BogleMelon,

That is my rule. I do not reduce my number due to AA.

KlangFool

bstewie
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Re: Net-worth rule of thumb for house purchase?

Post by bstewie » Wed Aug 14, 2019 9:35 pm

KlangFool wrote:
Wed Aug 14, 2019 7:40 pm
rbaldini wrote:
Wed Aug 14, 2019 7:38 pm
KlangFool wrote:
Wed Aug 14, 2019 7:36 pm
OP,

The net worth excluding the house should be 2.5 times or greater than the house's price.

KlangFool
Thanks for sharing. I know you are quite conservative when it comes to home ownership. I don't agree, but to each his own. :sharebeer
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool
I like the intent behind this, but it doesn’t scale to [V]HCOL areas for young, high income earners who want accommodations beyond a rental. Are they taking on risk by avoiding such a conservative rule? Yes, but life isn’t all black and white.

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Nate79
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Re: Net-worth rule of thumb for house purchase?

Post by Nate79 » Wed Aug 14, 2019 9:36 pm

I don't really find the comparison to buying a home to net worth to be relevant. The scenarios and reasoning are way too out there and ignore the alternative actions someone could make. Comparison to income is more relevant as a consumption item no different than buying any other large item.

I have never heard a single major financial writer or advisor make any similar recommendations.

student
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Re: Net-worth rule of thumb for house purchase?

Post by student » Wed Aug 14, 2019 9:45 pm

I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.

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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Wed Aug 14, 2019 9:49 pm

student wrote:
Wed Aug 14, 2019 9:45 pm
I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.
student,

1) How do you plan to pay your mortgage when you are unemployed and/or your income disappear?

2) In the worst-case like the Asian Currency Crisis and Texas Saving & Loan Crisis, you have to short sell your house and move to another country/region in order to find employment.

KlangFool

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Re: Net-worth rule of thumb for house purchase?

Post by Nate79 » Wed Aug 14, 2019 9:51 pm

KlangFool wrote:
Wed Aug 14, 2019 9:49 pm
student wrote:
Wed Aug 14, 2019 9:45 pm
I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.
student,

1) How do you plan to pay your mortgage when you are unemployed and/or your income disappear?

2) In the worst-case like the Asian Currency Crisis and Texas Saving & Loan Crisis, you have to short sell your house and move to another country/region in order to find employment.

KlangFool
How do you plan to pay the rent if you lose your income in the alternative scenario since on an apples to apples comparison the monthly expense is the same?

student
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Re: Net-worth rule of thumb for house purchase?

Post by student » Wed Aug 14, 2019 9:53 pm

KlangFool wrote:
Wed Aug 14, 2019 9:49 pm
student wrote:
Wed Aug 14, 2019 9:45 pm
I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.
student,

1) How do you plan to pay your mortgage when you are unemployed and/or your income disappear?

2) In the worst-case like the Asian Currency Crisis and Texas Saving & Loan Crisis, you have to short sell your house and move to another country/region in order to find employment.

KlangFool
I said income is the main factor and I did not say it is the only factor. So having an emergency fund should smooth things over. I bought an el cheapo condo and I paid it off years ago.

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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Wed Aug 14, 2019 9:57 pm

Nate79 wrote:
Wed Aug 14, 2019 9:51 pm
KlangFool wrote:
Wed Aug 14, 2019 9:49 pm
student wrote:
Wed Aug 14, 2019 9:45 pm
I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.
student,

1) How do you plan to pay your mortgage when you are unemployed and/or your income disappear?

2) In the worst-case like the Asian Currency Crisis and Texas Saving & Loan Crisis, you have to short sell your house and move to another country/region in order to find employment.

KlangFool
How do you plan to pay the rent if you lose your income in the alternative scenario since on an apples to apples comparison the monthly expense is the same?
Nate79,

Do you want to claim that terminating 1 year rental agreement is at the same size and scale as foreclosing a house?

KlangFool

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Re: Net-worth rule of thumb for house purchase?

Post by Nate79 » Wed Aug 14, 2019 10:08 pm

KlangFool wrote:
Wed Aug 14, 2019 9:57 pm
Nate79 wrote:
Wed Aug 14, 2019 9:51 pm
KlangFool wrote:
Wed Aug 14, 2019 9:49 pm
student wrote:
Wed Aug 14, 2019 9:45 pm
I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.
student,

1) How do you plan to pay your mortgage when you are unemployed and/or your income disappear?

2) In the worst-case like the Asian Currency Crisis and Texas Saving & Loan Crisis, you have to short sell your house and move to another country/region in order to find employment.

KlangFool
How do you plan to pay the rent if you lose your income in the alternative scenario since on an apples to apples comparison the monthly expense is the same?
Nate79,

Do you want to claim that terminating 1 year rental agreement is at the same size and scale as foreclosing a house?

KlangFool
Why would you terminate the rental and owe a 1 year lease penalty? If you can afford the 1 year of rent under the lease agreement you can afford 1 year of house payments as you weather the storm - that's what an emergency fund is for. If you can't afford rent you are now homeless. If you can't afford to pay your mortgage I would much rather have the extra time to go thru the very long foreclosure process as I try to find any work to be able to pay the mortgage or future rent.

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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Wed Aug 14, 2019 10:12 pm

Nate79 wrote:
Wed Aug 14, 2019 10:08 pm
KlangFool wrote:
Wed Aug 14, 2019 9:57 pm
Nate79 wrote:
Wed Aug 14, 2019 9:51 pm
KlangFool wrote:
Wed Aug 14, 2019 9:49 pm
student wrote:
Wed Aug 14, 2019 9:45 pm
I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.
student,

1) How do you plan to pay your mortgage when you are unemployed and/or your income disappear?

2) In the worst-case like the Asian Currency Crisis and Texas Saving & Loan Crisis, you have to short sell your house and move to another country/region in order to find employment.

KlangFool
How do you plan to pay the rent if you lose your income in the alternative scenario since on an apples to apples comparison the monthly expense is the same?
Nate79,

Do you want to claim that terminating 1 year rental agreement is at the same size and scale as foreclosing a house?

KlangFool
Why would you terminate the rental and owe a 1 year lease penalty? If you can afford the 1 year of rent under the lease agreement you can afford 1 year of house payments as you weather the storm - that's what an emergency fund is for. If you can't afford rent you are now homeless. If you can't afford to pay your mortgage I would much rather have the extra time to go thru the very long foreclosure process as I try to find any work to be able to pay the mortgage or future rent.
Nate79,

In a recession, a person may be unemployed long enough that he used up all his emergency fund.

<< If you can't afford to pay your mortgage I would much rather have the extra time to go thru the very long foreclosure process>>

In a recession, a person that can relocate has a better chance to find a new job.

KlangFool

mnnice
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Re: Net-worth rule of thumb for house purchase?

Post by mnnice » Wed Aug 14, 2019 10:32 pm

I don’t think a certain percentage is a max. But as a retired person sooner or later too much house would make you un-retired :wink:.

For example, Broke Bob receives $1,000,000 inheritance and gives notice to his landlord that he presently pays $1,000 a month in rent. He falls in love with a $900,000 house and buys it with cash as his residence. The remaining $100,000 is not going support a $900,000 house (at least not in a long term sustainable way).

Less house is always going to be “safer” regardless of leverage used or not used.

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Re: Net-worth rule of thumb for house purchase?

Post by CFM300 » Wed Aug 14, 2019 11:36 pm

KlangFool wrote:
Wed Aug 14, 2019 7:55 pm
rbaldini wrote:
Wed Aug 14, 2019 7:49 pm
KlangFool wrote:
Wed Aug 14, 2019 7:40 pm
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool
Not following. Suppose I have $250k. I buy a $100k house outright (so net worth > 2.5x house), leaving me with $150k in stock....
rbaldini,

As per your example, you need 350K. After buying the house, you only have 150K = 1.5 times. I do not care about the house value. Only the house price when you choose to buy. I assume that the house could drop to zero.

KlangFool
I don't understand your reasoning. Originally, you said that you need 2.5x net worth excluding the home value in order to endure a 50% drop in the stock market and still have money to pay off the mortgage and move elsewhere.

But in rbaldini's example, there is no mortgage payment. The person has bought the house outright. Why do they need an independent net worth of 2.5x the value of the house? They don't need to pay off the mortgage to move elsewhere, because they already have. They can just sell the house for whatever amount and move.

DoctorPhysics
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Re: Net-worth rule of thumb for house purchase?

Post by DoctorPhysics » Wed Aug 14, 2019 11:47 pm

If I followed some 2.5x net worth rule before buying a house I would still be waiting to enter the housing market 7 years later in my VHCOL area.

It can really depend on your circumstances, needs, job stability, housing area, and ability to take a risk.

EnjoyIt
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Re: Net-worth rule of thumb for house purchase?

Post by EnjoyIt » Thu Aug 15, 2019 1:45 am

If I ended up with a house that is so underwater that I need to sell 50% of my assets to get out, I would just let the bank foreclose on it, take the credit hit, and move on.
A time to EVALUATE your jitters. | https://www.bogleheads.org/forum/viewtopic.php?f=10&t=79939&start=400#p5275418

mighty72
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Re: Net-worth rule of thumb for house purchase?

Post by mighty72 » Thu Aug 15, 2019 2:06 am

Generic rules apply to generic person. Networth x times your house price is not a good metric IMHO. I live in a vhcol area, so anyone who wants to buy a average single family home would need x times 800k. For most folks, they would be renting till retirement. Now, renting is fine too.

My metric was that I pay 20% down + closing costs. I have another 5% to cover move in costs and appliances. My house was new so had warranty for a year on everything. I also should have 6 months of expenses in cash. Both me and my spouse work & have reasonably stable jobs so it helped. If I were conservative, I would have 1 year of expenses

anoop
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Re: Net-worth rule of thumb for house purchase?

Post by anoop » Thu Aug 15, 2019 2:26 am

You could figure out how much income is being generated from your assets and then apply the usual formula for affordability to that income. For example, if income from investments is $50K per year and the rule of thumb says house should be no more than 3x annual income, then you can afford a $150K house.

KlangFool
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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Thu Aug 15, 2019 7:04 am

CFM300 wrote:
Wed Aug 14, 2019 11:36 pm
KlangFool wrote:
Wed Aug 14, 2019 7:55 pm
rbaldini wrote:
Wed Aug 14, 2019 7:49 pm
KlangFool wrote:
Wed Aug 14, 2019 7:40 pm
This number allows a person to take a 50% stock market drop and still have enough money to pay off the mortgage and move elsewhere.

KlangFool
Not following. Suppose I have $250k. I buy a $100k house outright (so net worth > 2.5x house), leaving me with $150k in stock....
rbaldini,

As per your example, you need 350K. After buying the house, you only have 150K = 1.5 times. I do not care about the house value. Only the house price when you choose to buy. I assume that the house could drop to zero.

KlangFool
I don't understand your reasoning. Originally, you said that you need 2.5x net worth excluding the home value in order to endure a 50% drop in the stock market and still have money to pay off the mortgage and move elsewhere.

But in rbaldini's example, there is no mortgage payment. The person has bought the house outright. Why do they need an independent net worth of 2.5x the value of the house? They don't need to pay off the mortgage to move elsewhere, because they already have. They can just sell the house for whatever amount and move.
The goal of the rule is to make sure that even if the house worth noting, it would not matter to you.

KlangFool

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Thu Aug 15, 2019 7:36 am

Nate79 wrote:
Wed Aug 14, 2019 9:51 pm
How do you plan to pay the rent if you lose your income in the alternative scenario since on an apples to apples comparison the monthly expense is the same?
The distinction is that, in one case, you might be contractually obligated to pay one or two extra months’ rent (cancel fee), whereas in the other you might owe a lender hundreds of thousands of dollars.

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Thu Aug 15, 2019 7:39 am

EnjoyIt wrote:
Thu Aug 15, 2019 1:45 am
If I ended up with a house that is so underwater that I need to sell 50% of my assets to get out, I would just let the bank foreclose on it, take the credit hit, and move on.
Fair point.

RollTide31457
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Re: Net-worth rule of thumb for house purchase?

Post by RollTide31457 » Thu Aug 15, 2019 7:47 am

KlangFool wrote:
Wed Aug 14, 2019 7:36 pm
OP,

The net worth excluding the house should be 2.5 times or greater than the house's price. For example, if you want to buy a 400K house, your net worth excluding the house should be 1 million. The net worth should be after you pay the 20% down payment. In this case, the exact number would be 1.08 million or greater.

KlangFool

Agree! This is excellent counsel.

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Thu Aug 15, 2019 7:55 am

To be clear, I think any net-worth-based rule of thumb should be used in tandem with a income-based rule, if at all.

That being said, the more I think about income-based rules, the more I am skeptical of them. One can always reduce the PITI of a home purchase by simply putting more money down. But this is not a free lunch: you have to sell productive, liquid assets to achieve this! Assuming I had enough net worth to handle any big market dips (where high net worth comes in), I'd rather save incrementally less later while paying a high PITI than have to remove a large lump sum from the stock market to achieve a lower PITI.

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Re: Net-worth rule of thumb for house purchase?

Post by njuser » Thu Aug 15, 2019 8:01 am

"The goal of the rule is to make sure that even if the house worth nothing, it would not matter to you.

KlangFool"

This may be very conservative, but it is the rule I follow as well. I agree it would be hard to follow in a place like NYC or SF, but I would never live in a VHCOL place like that, either.
Last edited by njuser on Thu Aug 15, 2019 8:02 am, edited 1 time in total.

KlangFool
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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Thu Aug 15, 2019 8:02 am

DoctorPhysics wrote:
Wed Aug 14, 2019 11:47 pm
If I followed some 2.5x net worth rule before buying a house I would still be waiting to enter the housing market 7 years later in my VHCOL area.

It can really depend on your circumstances, needs, job stability, housing area, and ability to take a risk.
DoctorPhysics,

And, why would that be a bad thing? Over the next recession, you will be able to buy a foreclosed house from those overstretched themselves financially.

KlangFool

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Thu Aug 15, 2019 8:07 am

KlangFool wrote:
Thu Aug 15, 2019 8:02 am
DoctorPhysics wrote:
Wed Aug 14, 2019 11:47 pm
If I followed some 2.5x net worth rule before buying a house I would still be waiting to enter the housing market 7 years later in my VHCOL area.

It can really depend on your circumstances, needs, job stability, housing area, and ability to take a risk.
DoctorPhysics,

And, why would that be a bad thing? Over the next recession, you will be able to buy a foreclosed house from those overstretched themselves financially.

KlangFool
To be fair to DoctorPhysics, home ownership at a given PITI is *often* superior to renting at the same price. The risks that we talked about are there, and should be taken into account, but one should also consider the full spectrum of outcomes, including the up side. My wife and I benefitted greatly from purchasing our house (so far), and we certainly did not have 2.5x the house's value in net worth when we purchased.

SQRT
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Re: Net-worth rule of thumb for house purchase?

Post by SQRT » Thu Aug 15, 2019 8:12 am

No good rule of thumb here. Depends on personal circumstances, especially age and where you live. A 30 year old trying to break into the housing market in a VHCOL area will have a much higher percentage of his net worth tied up in his principal residence than a 65 year old retiree living in a VLCOL area.

As long as you can reasonably support the costs of the house, you are OK. Obviously, you would want a appropriate cushion based on your circumstances. Banks are pretty good (not perfect) at determining this.

Surely this is self evident? Yet we will debate this for several hundreds of posts, no doubt.

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rbaldini
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Re: Net-worth rule of thumb for house purchase?

Post by rbaldini » Thu Aug 15, 2019 8:12 am

mnnice wrote:
Wed Aug 14, 2019 10:32 pm
I don’t think a certain percentage is a max. But as a retired person sooner or later too much house would make you un-retired :wink:.

For example, Broke Bob receives $1,000,000 inheritance and gives notice to his landlord that he presently pays $1,000 a month in rent. He falls in love with a $900,000 house and buys it with cash as his residence. The remaining $100,000 is not going support a $900,000 house (at least not in a long term sustainable way).

Less house is always going to be “safer” regardless of leverage used or not used.
Agreed. According to my rule, he shouldn't have bought anything over $500k. 8-)

MichCPA
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Re: Net-worth rule of thumb for house purchase?

Post by MichCPA » Thu Aug 15, 2019 8:17 am

I would submit that one's net worth should be compared both the the price of the house and the mortgage size. I get the impression that those two issues have been confused so far.

If you have the full payoff of your mortgage in bonds or 2x in stocks, or some combination of those amounts, you can easily afford the mortgage. I would argue if you have three years of minimum payments saved up using that bond stock mix, you are fine.

As to the price of the house, the costs cannot stop you from amassing retirement assets that can pay for your living costs, including a mortgage if you still have one. Its a much lower bar than the mortgage test because a fully paid house drastically reduces the base cost of living. Assuming you need to move during a widespread recession, you are likely to both be selling low and buying the new house low, which reduces loss exposure.

I would also agree that income generated from work and investments is critically important. If your yearly investment income is equal to the mortgage payment + cost of living, it is unlikely that the income from those investments would drop enough in a recession that you couldn't live off of some combination of investment income or sales of investments.

There isn't a formula per se.

KlangFool
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Re: Net-worth rule of thumb for house purchase?

Post by KlangFool » Thu Aug 15, 2019 8:18 am

rbaldini wrote:
Thu Aug 15, 2019 8:07 am
KlangFool wrote:
Thu Aug 15, 2019 8:02 am
DoctorPhysics wrote:
Wed Aug 14, 2019 11:47 pm
If I followed some 2.5x net worth rule before buying a house I would still be waiting to enter the housing market 7 years later in my VHCOL area.

It can really depend on your circumstances, needs, job stability, housing area, and ability to take a risk.
DoctorPhysics,

And, why would that be a bad thing? Over the next recession, you will be able to buy a foreclosed house from those overstretched themselves financially.

KlangFool
To be fair to DoctorPhysics, home ownership at a given PITI is *often* superior to renting at the same price. The risks that we talked about are there, and should be taken into account, but one should also consider the full spectrum of outcomes, including the up side. My wife and I benefitted greatly from purchasing our house (so far), and we certainly did not have 2.5x the house's value in net worth when we purchased.
rbaldini,

My PITI is 20% to 30% lower than renting. In this case, it is clear cut that it is superior. They are not at the same price.

So, my complete set of rule.

A) PITI (20% downpayment and 30 years fixed rate) at 20% to 30% lower than renting. Do not need house price appreciation.

B) Net worth excluding the house = 2.5 times the house price. Do not care if the house is worth zero.

KlangFool

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Re: Net-worth rule of thumb for house purchase?

Post by Bb073084 » Thu Aug 15, 2019 8:18 am

KlangFool wrote:
Wed Aug 14, 2019 9:49 pm
student wrote:
Wed Aug 14, 2019 9:45 pm
I don't understand the net-worth rule of thumb for buying a house either. To me, it is the income (earned or by investment) that is the main factor.
student,

1) How do you plan to pay your mortgage when you are unemployed and/or your income disappear?

2) In the worst-case like the Asian Currency Crisis and Texas Saving & Loan Crisis, you have to short sell your house and move to another country/region in order to find employment.

KlangFool
Not a great solution but you can walk away from the home mortgage and just kill your credit in that situation...

cherijoh
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Re: Net-worth rule of thumb for house purchase?

Post by cherijoh » Thu Aug 15, 2019 8:22 am

rbaldini wrote:
Wed Aug 14, 2019 2:32 pm
We get questions all the time about whether one should and could purchase a house of some price. There are general rules of thumb as regards PITI relative to income - e.g. recurring housing expenses shouldn't exceed x% of income, or that that total debt payments shouldn't exceed y% of income, etc.

But I don't know of any rules of thumb regarding net worth - e.g. don't buy a house whose value exceeds some factor of your net worth. One could imagine all sorts of formulas. Maybe those are around and I've just forgotten about them.

Here's a simple rule I came up with. It is based on the following scenario: suppose you purchased a home, and very quickly thereafter the price of the home declined by some realistic x%, *and* you suddenly needed to sell the house (perhaps your income has dropped indefinitely such that you can no longer afford the recurring payments). The primary risk with purchasing a house, as compared to renting, is that you are most likely taking on quite a bit of debt, commonly 80% of the house's sale price. If you want to be able to pay that debt off at the time of sale, your liquid assets need to be large enough to make that payment.

To a first order approximation, you have liquid assets of $L prior to the purchase. After the purchase, you paid $P*d (where P is home price paid, and d is proportion down payment) of your liquid assets to the lender. The house then drops to a value $P*(1-x), which you recoup on the sale. You now need to pay the remaining amount on the loan, approximately $P*(1-d).

To be able to afford this, you need L - P*d + P*(1-x) > P*(1-d). Or

L > x*P

In other words, you should only buy a house if you have enough liquid assets to draw on to pay for a pessimistic dip in house price of x%. It's up to you what to use for x. If we imagine a worst-case scenario to be something like a house price drop of 50%, then the rule is that you should have liquid assets in excess of half of the home's price. If you want to buy a $500k house, you should be able to, right now, come up with $250k cash if you had to. What counts as liquid is somewhat subjective. For example, you could withdraw contributions from a Roth IRA if necessary, but you might not want to factor that in, given the opportunity cost of doing so.

Obviously this smooths over a lot of complications - hence, rule of thumb. It ignores the transaction costs of buying and selling; that some of the debt will have already been paid off; that your liquid assets are not fixed, and while they hopefully grow during your home ownership tenure, they may decrease for the same reason that the house price decreases; that this might happen 5 or 10 years down the line instead of almost immediately. But it seems like a decent starting point.

I have never actually sold a house before (bought our first two years ago), so I may be making some fundamentally flawed assumptions. Let me know. Thoughts?
By tying housing purchase to net worth, you are limiting the ability for younger people to purchase houses. You also are ignoring the fact that if you didn't have a house you would still be stuck paying rent.

When I purchased my first house (a condo) I was a few years out of college and had very little net worth but a lot of human capital. Interest rates were also very high. After a couple of years, I refinanced to a lower rate and at that point my condo (PIT&I plus HOA dues) cost less after including the impact of being able to itemize deductions than an equivalent apartment would have cost. So home ownership was contributing to my net worth.

Locked