If you are reading this text, statistically, you probably own the place where you live — 60% of Quebecers do.
Also, the value of your home has probably experienced an increase that has exceeded inflation in recent years. A single-family home is worth an average of $547,400 in Quebec. That’s more than double the price of 10 years ago.
The result is that many people would burst out laughing if asked to buy their own house at today’s going prices.
This is a problem. At some point, some of the 40% of renters in the province are going to think about buying a home. Especially the younger ones. And they are going to have to go into massive debt to do so.
So how do you know if you can afford the most expensive purchase of your life? How do you know which house to choose?
Sam Dogen, financial author of the bestselling book Buy This, Not Thatcreated the 30/30/3 rule 15 years ago, which has been widely adopted since then.
Here’s what it’s all about.
Rule no 1: Do not spend more than 30% of your gross income on your mortgage payments.
The first rule says that mortgage payments should not exceed 30% of our gross income. So in concrete terms, a couple with a gross income of $100,000 per year should not pay more than $30,000 in mortgage, or $2,500 per month.
Rule no 2: have in hand 30% of the purchase amount of the value of the desired property.
This one may make some people cringe, so let me explain. Of this amount, 20% will be used for a down payment. Such a down payment shows that we are serious about our approach. It allows us to borrow a smaller amount from the bank, therefore paying less in interest over the term of the loan repayment. The person who puts down 20% is also less affected by interest rate fluctuations: each rate increase hurts them less, because they have borrowed less money.
And the remaining 10%? This money can be invested in easily liquidated financial assets. It is used for unforeseen events. Renovations. Foundations. Construction. Transformation. Demolition. Improvement. Anything that ends up as a “tion” and is expensive.
Rule no 3: Buy a house or condo worth about three times the household’s gross annual income.
A household with an income of $100,000 per year should aim to buy a home worth around $300,000. This rule is more elastic than the others, and some people talk about a range of 3 to 4.5 times the value of gross annual income.
There you have it. It’s the 30/30/3 rule in real estate.
You do your calculations, and your reaction is to say that this formula does not apply because you live in an expensive city?
Don’t worry: this formula applies. It tells you that you don’t (yet) have the means to make your real estate purchase.
This rule is not a law. But it exists to remind us that an exciting decision when the unemployment rate in Quebec starts with the number 5 could prove impossible to bear if it were to one day – we do not hope – start with the number 10.
“Risk is what remains when you think you have thought of everything,” wrote author Carl Richards.
Debt is risk. Don’t let anyone tell you otherwise.
Rent or buy?
These days, many people are wondering whether buying a place to live is better than renting.
The first thing to know is that both options involve spending irrecoverable amounts of money. By calculating them, we can compare them.
In the case of renting, the irrecoverable amount is easy to calculate: it is the rent.
For the purchase, the irrecoverable amounts include the cost of giving up the return on the down payment and interest (which could be invested elsewhere), school and municipal taxes, notary fees, transfer taxes, higher insurance costs and maintenance costs, among others.
To do a simple calculation, Benjamin Felix, chief investment officer and portfolio manager at PWL Capital, estimates that a sunk cost is 5% of the value of a home per year.1
So, if you can rent a $500,000 house or condo for less than $25,000 per year ($2,083 per month), renting is cheaper. Otherwise, buying will be better.
And note that this rule is very conservative, perhaps even too conservative. It was calculated in 2019, when mortgage rates were at their lowest, which is of course no longer the case today. In our example, if we use 6% of sunk costs rather than 5%, we arrive at a rent of $2,500 per month, beyond which buying becomes preferable.
As I wrote last week, buying a house is a form of forced savings. The tenant who has a reasonable rent, but doesn’t put any money aside, is not getting rich.
After a year, the difference is barely visible. After a lifetime, we are somewhere else.
Finally, a word for young couples who live in apartments and who are freaking out because they are going to have a child and cannot find a house.
At least for the first few years of his life, your child will not need a yard. Whether he lives in a big house or not is of no interest to him. A newborn does not know the difference between rent and a mortgage.
Take it one step at a time. Don’t put pressure on yourself that doesn’t exist.
1. Read the text (in English) by Benjamin Felix of PWL Capital