Can you afford your dream home after taking the 3-3-5 test?
June 20, 2014 33 Comments
Below is the original article in my book for your reference:
A simple affordability test
Daniel is a single in his mid-thirties. He is staying with his parents now but is considering moving out on his own. He has a savings of $120,000 and is drawing a monthly income of $6,000. He is eyeing a studio unit in a newly-launched private residential project downtown as his bachelor’s pad.
Joshua and Esther are newly-weds. They have been looking for their ideal home for some time. They want to buy a three-bedroom flat in a condominium near to where Esther’s parents stay. They have a combined salary of $10,000 and savings of $150,000.
Both parties write in about buying their dream home, and drop the big question at the end:
“Is our money enough to buy the property?”
When buying properties, most people only focus on whether they have sufficient funds to settle the downpayment. But they miss the more important aspect of whether they are able to service the housing mortgage in the future.
The 3-3-5 rule
There are some general guidelines to check whether a property is affordable to you. For the sake of easy memorization, let’s call it the 3-3-5 rule.
Rule 1: 30% of property price
Your initial capital should at least be 30 percent of the property’s asking price, in order to pay for the downpayment, transaction costs and other miscellaneous expenses.
Rule 2: 1/3 of monthly salary
Your monthly mortgage payment should not exceed one-third of your monthly salary.
Rule 3: 5 times of annual income
The purchase price of the property cannot exceed five times of your annual income.
For Daniel, he can only afford to buy a property priced below $360,000. Since he relies only on a single income to support his property, he has higher risk than the couple. His approach should be more conservative.
As for Joshua and Esther, their budget cannot go beyond $500,000 because of the limitation in their initial capital. If they want to increase their budget, they should find ways to save more before plunging into the market.
Why you need to be conservative?
Sounds tough, doesn’t it?
But so far for all my property purchases, I have been able to stick to the 3-3-5 rule.
To buy an investment property, you’d rather be conservative than aggressive. To support your home, you’d better be safe than sorry.
If you have problems even paying for 30 percent of the property, you can’t really afford it.
If the value of your target property far exceeds five times of your annual income, you are either buying an overpriced property or buying a property out of your reach financially.
Many people buy their home without thinking carefully. They are tempted to use the government housing grant or subsidy for first-time buyers.
You may not aware of the fact that this small amount of subsidy, say, $30,000 or $40,000, can easily be offset by the fall in your property’s value when the bear market comes after your purchase. You are left to pay the outstanding loan from an overpriced property.
Interest rates can go up. Property prices can go south. Jobs can be lost.
Do you have the holding power to go through the next property cycle? Would you still be able to service your housing mortgage under all circumstances? Do you have the cash reserve to top up the difference in case your property’s value drops below the market price?
If you can’t give a definite answer, you are not ready yet.
In a sea of comments, let me clarify three points here:
1. Income level and savings out of reach?
The characters in the case study probably fall into the ‘high-income’ group. And the income gap between the rich and the poor is getting wider in Singapore. Read the article “Ultra-rich club gets bigger and wealthier” in today’s Straits Times and My Paper.
Nonetheless, how much you earn may be out of your control, but how much you can save is completely determined by you.
2. The 3-3-5 rule unrealistic?
Some readers think that practising the 3-3-5 rule is infeasible in today’s property market.
I understand that it is unpleasant to find out that you can’t really afford your dream home after taking the 3-3-5 test. If I were a developer or an agent, I would definitely come up with a 1-2-10 rule so that everyone could happily jump into the market and buy something.
We are having the ‘boiling frog’ phenomenon here: When people are in a high-price environment for too long, they will gradually think that it is normal and acceptable to pay high prices. Similarly, when people are in a prolonged boom of the property market, they will forget what is a ‘value-for-money’ home, or why it is necessary to calculate the ROI of an investment property.
When market prices are climbing rapidly, salespeople will tell customers that it is impossible to go back to the low prices in the past. However, history has proved time and again that they are wrong. Cycles do repeat themselves over the past few decades.
And it is when market prices have been corrected sharply that people begin to realize that many buyers have overpaid for their properties bought during the last peak of the property cycle. These buyers are going to pay the price of holding their overpriced properties ‘for the long-term’ to wait for break-even, while missing the opportunities to buy when prices become reasonable again.
3. Use your own judgment
Developers can sell at future prices and sellers can market at unreasonably high prices. But as buyers, it doesn’t mean that we have to take whatever we are offered. Before we commit to any big purchase, we have the right to exercise our individual judgment to determine whether the product prices are reasonable.
As a conservative value investor, I can say that I bought all my private properties strictly in compliance with the 3-3-5 rule. And I certainly know many people who can do the same too.
It is not it can’t be done. It is people who don’t know that it can be done, or they choose to believe that it can’t be done.