Applying the 20/30/3 Rule: How to Make An Informed Home Buying Decision
Buying a house is an important decision that must be made carefully. The 20/30/3 can help you make a decision that won’t harm your finances.
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“Interest rates are low, it is time to buy a house” is the default way many people make home-buying decisions. This approach was one of the many reasons for the 2008/2009 financial crisis as people took mortgages that did not make sense given their financial situation.
While the mortgage rate is important, it should not be the sole reason you buy a house. You should consider various personal finance factors before deciding to buy a house or continue renting.
In contrast to a simplistic obsession with mortgage rates, the 20/30/3 rule provides a comprehensive guideline that will ensure you make a choice that is well adapted to your personal finance situation.
In this article, we will consider what this rule is all about and how you can apply it to yourself. We’ll cover:
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The 20/30/3 is a quick, yet comprehensive, way for you to decide whether you are ready to buy a house and, if so, how much house you should buy.
There are three key components of this rule:
The first part of this rule states that the monthly mortgage you will pay on the house (also known as the equated monthly installment [EMI]) you want to purchase should not exceed 20% of your monthly income.
This rule ensures that the burden of repaying the mortgage does not overwhelm your monthly budget – leading you to cut down on other important expenses or savings.
For example, the popular 50/30/20 rule requires that you spend 50% of your income on needs, 30% on wants, and save the remaining 20%.
Now imagine that your monthly mortgage repayment is already 50% of your income. This means that your other needs – food, electric bill, clothing, transport, car insurance, and health insurance, among others – have to come from the money you should have spent on wants and the one you should have saved.
Doing this every month will make it difficult for you to save the money you need to build wealth and achieve your financial goals.
The second part of this rule states that you should have 30% of the home value available as cash or in cash equivalents (short-term investments that can be quickly turned into cash without losing value).
This 30% of home value consists of a 20% downpayment and a 10% financial cushion.
Why should you consider a 20% downpayment?
“Putting down 20% on a home purchase can reduce your monthly payment, eliminate private mortgage insurance (PMI) and possibly give you a lower interest rate,” according to Experian, a consumer credit reporting company.
However, while a 20% downpayment is not always required for Americans (especially for first-time home buyers), it is the standard for UAE expats. Only nationals can make do with a 15%, according to Kredium, a mortgage and property listing platform.
If you are a national, you should still make the 20% down payment given the advantages listed above.
What about the cash buffer?
A cash buffer (financial cushion) can also help you when unexpected situations make it difficult to repay your real estate mortgage in some months.
It is similar to an emergency fund in its usage. If you lose your job or some unexpected expenses make it difficult to meet up with mortgage repayment, the cash buffer can help keep your house while you work things out.
Why should you keep your down payment in cash and cash equivalents?
Though they might grow more in the stock market (stocks or ETFs), you cannot predict what the market will look like when you need the cash. If the market is down, you might have to sell your investments at a significant loss, jeopardizing your home purchase plan.
The final part of this rule states that the price of the property you are purchasing should not be more than three times your annual gross income (take-home pay).
Even if the home loan lender pre-approved you for a higher-valued property, you should not purchase the most expensive property you qualify for.
“If you settle on something below your max, you’ll have more wiggle room to put money into a high-yield savings account or pay for other costs like home renovations,” according to CNBC.
This is even more relevant in the UAE.
How so?
For properties worth more than AED 5 million (but less than AED 10 million), the required down payment increases to 25% for nationals and 30% for expats while for properties exceeding AED 10 million, it is 40% across the board, according to Kredium.
The 20/30/3 rule began life as the 30/30/rule. It was popularized by Sam Dogen, the founder of Financial Samurai.
Given the low mortgage rates in the US during the COVID-19 pandemic days, he wanted to ensure that people did not make the same mistakes they did leading up to the 2008/2009 Great Recession.
He argued that low mortgage rates and the desire for homeownership should not cause buyers (borrowers) to overextend themselves. The 30/30/3 rule was designed “to prevent buyers from the stress of owning a house they can’t afford.”
In this original formulation, mortgage payment was capped at 30% of gross income.
Source: Our Steward
However, as the global cost of living has increased given the interventions that followed COVID-19, some financial advisors have suggested that mortgage payments be capped at 20% of gross income instead.
Both rules continue to exist. It is, therefore, up to you to figure out what is most appropriate for your financial situation.
If you are using the 50/30/20 rule, for example, you need to consider how a mortgage payment of 30% of gross income will affect your ability to save 20% of your income. If you can still meet up, then you may choose the 30/30/3 rule, and vice versa.
Now that you know what the rule is about, it is time to use the 20/30/3 rule calculator to evaluate your financial situation.
How do you calculate household income?
If you are single, it is just your annual gross income (for our purpose). However, if you are married and your partner will also contribute towards a mortgage payment, then the household income is the sum of your income and your partner’s.
Suppose your partner will not contribute to the repayment, then your household income (for mortgage purposes) is still your annual gross income only.
You can visit the websites of various mortgage lenders and call their customer support to get this data.
For our example, the question will be whether you have AED 810,000 in cash and cash equivalents.
If you don’t meet up with the conditions, an alternative is to go for properties within a lower price range. For example, if AED 2,700,000 is too expensive based on your annual gross income and available cash (and cash equivalents), you can consider going for properties valued between AED 2,000,000 and 2,500,000.
Of course, you can always sell this property to buy a more-valued one once your financial situation improves.
However, if you don’t want to buy something lower-valued, then you have to wait till your household income increases and/or you have enough cash for the required down payment.
Interestingly, Dogen admitted that some people will want to violate his rule, seeing it as too stringent in a low-rate environment.
With average residential mortgage rates in the UAE hovering between 2.99% and 4.99%, we can say that the UAE is a low-rate environment.
Violation of the 20/30/3 can take three forms:
If you decide to violate the first part of the rule, Dogen suggests that you should consider:
The problem is that purchasing a property you can’t afford in expectation of increased income is risky. What if things don’t work out as you planned and the expected increase in income does not materialize?
What about the second part of the rule? In the UAE, there is little wriggle room regarding down payment. You can only make a downpayment of less than 20% if you are a national and the house’s cost is less than AED 5 million.
Ignoring the 10% cushion is even more dangerous. You might assume that no emergencies will arise in the next year, for example, and decide to use that period to save up the cushion. But what if you lose your job three months later?
The only time you should consider a smaller cushion is if you already have a large emergency fund that can cover your needs (including mortgage payments) and wants for the next six months (as financial experts have advised).
For the third part of the rule, Dogen noted that “you could stretch this final rule and extend the home value by up to five times your annual household income” in a low-rate environment.
However, if you decide to purchase a property worth 5X your annual income, you still need to evaluate if you can afford the monthly mortgage payment and downpayment (plus cushion).
Therefore, you can only break the third rule if you can break the first and the second.
Given the risks involved, it is not advisable to break the 20/30/3 rule. However, if you strongly believe that you can deal with the risk, and your financial advisor agrees, you may go ahead.
If you want to use the 20/30/3 rule, two things are fundamental: you have a budget that you stick to and you are actively saving money.
Limiting your mortgage payment to 20-30% of your income only makes sense if you have a budget. Also, having cash to pay for the down payment and for a cushion is only possible if you know how to save money for a house down payment.
All of these require sound money management and one critical part of money management is learning how to stop spending money and saving it.
One way to solve the overspending problem is to use Maly’s multiple debit cards. You can create a debit card for your main expense category and load the cards with the exact budgeted amount for that category.
Since these are debit cards, you cannot overdraw them. Once you have exhausted your budget for an expense category, transactions done with the card will start failing. This will help you avoid overspending on one category at the expense of another (which will happen when all your funds are in one card).
Also, Maly’s AI Money Mentor can be your finance coach. It can help you create a budget, a debt repayment strategy (for student loans, and credit card debt, among others), and a personalized wealth or financial plan. AI money management is a very useful alternative if you can’t afford a financial advisor.
Finally, you can increase your financial knowledge with MalyGPT. As a financial counterpart to ChatGPT, it will answer your finance-related questions.
Want more information about the 20/30/3, emergency fund, investing, etc? MalyGPT can provide useful information. Don’t be surprised that generative AI in finance can significantly improve your financial education.
[Are you ready to better manage your finances so you can be ready to purchase your home? Download the Maly app for free today to access useful tools that will help you become a better money master.]
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