When you’re in the market to buy your first home, the process can be overwhelming and confusing, but also exciting. What features in a house or condo do you want most? How do you pick a good realtor? How much will the bank lend you? And the biggest question: Can you afford to buy a house? The new first-time homebuyers “Rule of 200” will address the final question – can you afford to buy this house.
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Qualifying for a Mortgage
One of the many steps when you’re a first-time homebuyer, is to think about financing. Many people start with their bank or mortgage broker to get pre-approved for a mortgage. They will ask you about your income, your savings, any other loans you have (such as student debt or a car loan), and they will check your credit score.
The bank will then give you a number. The maximum amount of mortgage loan that you are pre-approved for. How do they get this number?
The 2 Affordability Rules for First-Time Homebuyers
The bank uses two affordability rules to see how much home a first-time homebuyer can afford.
- Your monthly housing costs should be under 32% of your gross monthly income. What does that mean? Your “gross monthly income” is how much you earn before income tax and other automatic deductions come off.
- Your monthly debt load should be under 40% of your gross monthly income. The “debt load” is the monthly mortgage payments plus any other loan payments you may have.
That means that no, you do NOT have to pay off your student loans before buying a house!
First-time homebuyers are often pleasantly surprised at just how much they have been pre-approved for.
But – and this is a very big but – SHOULD you buy a house up to your pre-approved level? Remember that banks make money from the interest you pay on your mortgage. So it’s in their best interest (no pun intended) to lend you the maximum amount they think you can afford to repay without going into default. However, this may make your monthly payments so high that you can’t accomplish your other financial goals – buying a car, saving for your retirement, saving for your kids’ education, travel, or even paying the monthly credit card bills.
RELATED READING: Risk-free saving for a down payment!
Let’s Look at an Example
Sam has been working for a while, pays $1,500/month in rent, pays $400/month on a student loan, and including last year’s raise now earns $100,000 per year. That’s a gross (before taxes and deductions) monthly salary of $8,333. Sam has also saved for the past few years and has $50,000 for a down payment.
Mortgage interest rates have gone up a bit, since Sam started saving, but are still relatively low at 3.5%.
The rules above apply to annual earnings as well as monthly. So, Sam would be able to afford – according to the bank – up to $32,000 per year in housing costs and up to $40,000 per year in total debt load.
On a monthly basis, that would be $2,667 in housing costs and $3,333 in total debt load. With a down payment of $50,000, Sam could be pre-approved to buy a house up to $560,000! Including mortgage insurance (because their down payment is less than 20% of the purchase price), the monthly payment would be about $2,650. That’s under the 32% rule. And including the student loan payment of $400 per month, they are still well under the 40% rule.
Sam is thrilled! They never thought they’d be looking for a half-million dollar house! Now, looking through the realty listings, Sam eyes some places that are MUCH nicer. And so big, too!
But Wait a Minute!
Is this a good idea?
Sam’s $100,000 gross annual income seems enviously high. That degree certainly paid off!
But that’s Sam’s gross income. What about net income?
Sam lives in Ontario, with a middle-of-the-road income tax rate, and each year has $27,860 in deductions automatically come off their paycheques. This includes income tax (federal and provincial), CPP (Canada Pension Plan) and EI (Employment Insurance).
Sam’s after-tax net income is just over $6,000 per month.
The 32% rule based on gross income is now nearly 45% of Sam’s net income. And the 40% total debt rule is now over 50% of Sam’s net income.
Sam is starting to wonder if buying a $560,000 house is the right move after all, for a first-time homebuyer. After all, there’s still food, transportation, and all the other costs of living. And the talk of rising interest rates later in the year makes Sam’s stomach knot up with anxiety.
Related post: Save thousands on groceries!
The Rule of 200 for First-Time Homebuyers
Sam has been comfortably paying $1,500 in rent each month for the past two years. They find that at the end of the month, there is still money left over to save. After all, that’s how they amassed the $50,000 down payment! Sam would be most comfortable paying $1,500 per month for the mortgage.
So here, finally, as I promised you from the start, is the Rule of 200 for First-Time Homebuyers!
Take your monthly rent, and multiply by 200. It’s so easy, you can even do it in your head! Just double your rent and add two zeros to the end. This gives the amount of mortgage that you can afford, with the same monthly payment you’re currently paying in rent. Add on your down payment (and subtract mortgage insurance if applicable) to get the selling price of the home.
The assumptions behind this rule are a 25-year mortgage and 3.5% interest rate.
Sam does the math. $1,500 x 200 works out to a mortgage loan of $300,000. Adding the $50,000 down payment Sam has saved, and subtracting the $9,000 mortgage insurance premium, they are looking for a house with a selling price of no more than $341,000. A $341,000 house gives Sam a monthly payment of just under $1,500.
This calculator from RateHub.ca will help calculate the CMHC mortgage insurance required when buying a home for less than 20% downpayment.
That feels MUCH better, and Sam maps out the open house route for the weekend ahead.
But What if Interest Rates Change?
The Rule of 200 only applies to mortgages of 25 years and 3.5% interest rate.
A 25-year mortgage is the industry standard, so we won’t look at changing that in terms of the Rule of 200.
Here is the Rule for other common interest rates:
That is, if your mortgage interest rate is 5.0%, multiply your current monthly rent by 170 instead of 200, to get your mortgage loan amount. Now, add on your down payment and subtract any mortgage insurance to get your final house purchase price.
Check current mortgage rates and more information for first-time homebuyers at Rate Supermarket!
Additional Costs for First-Time Homebuyers
Unfortunately, first-time homebuyers are often surprised by the extra costs of ownership as compared to renting.
In addition to your down payment, there are a number of additional costs due around the move-in date:
- Home inspection
- Legal fees
- Appraisal fees
- Land registration fees
- Land transfer tax
- Prepaid property tax and utility bills (if the current owner has already paid these, you need to reimburse them)
- GST on mortgage loan insurance (if applicable)
- Moving costs (even if your friends help you move)
Renters often overlook additional ongoing costs of home ownership that are currently paid by their landlord. As a first-time homebuyer, they will now face the full price:
- Property tax
- Home insurance
- Condo fees (if applicable)
How does the Rule of 200 Work if I Buy a Condo?
Remember to subtract your monthly condo fees from what you can afford to pay for housing. Then multiply by 200. This is now the mortgage amount that will be affordable for you.
For example, Sam wants to pay a total of $1,500 per month for the mortgage and condo fees combined. Recall that Sam currently pays $1,500 per month in rent, so they know this is a comfortable amount. But the condo fees are $300 per month, leaving Sam $1,200 for the mortgage. $1,200 x 200 is $240,000.
Sam could buy a house with a $300,000 mortgage or a condo with a $240,000 mortgage and have the same monthly costs for housing.
But What if I want a More Expensive House?
If you can afford more than you are currently paying in rent, keeping in mind all the additional costs listed above, then take what you’d like to pay for your mortgage each month and multiply by 200.
There are many ways to save money on housing costs, ranging from co-ownership (buying a house with a friend), to living close enough to work so that you can walk, to signing up for film shoots in your house. Check out my popular article on House Hacking for more.
If you are looking for a house with rental income, you can still use the Rule of 200. Simply add the rent you would charge your tenant, to the rent you are paying now, then multiply the total by 200. This will give your new MAXIMUM mortgage loan, which still keeps YOUR share of the payments the same as your current rent.
Just be aware that house hacking may come with associated costs. Your tenant’s rent cheque bounces – this has happened to us. Your tenant moves out and you discover his elderly dog was incontinent and now you have to replace all the flooring – ask me how I know this.
Using your home to generate extra income, so that you can afford a bigger and/or better house, can be a great idea. But be sure to have a plan for when that income suddenly drops or expenses are unexpectedly higher.
Keep in mind that buying a house that is comfortably within your budget can help you pay your mortgage off early.
Does the Rule of 200 Work for Other Loans?
You can use the Rule of 200 for any type of housing loan, such as an income property, cottage, or beach house. Remember that if you’re buying a secondary property the mortgage lender generally wants a 20% down payment. You will not require mortgage insurance at that point.
The Rule of 200 does NOT work for car loans, student loans, renovation loans, debt consolidation loans, lines of credit, etc. This is because the Rule of 200 requires a lending period of 25 years. These types of loans tend to be much shorter.
Assessment of the Rule of 200 for First-Time Homebuyers
The new Rule of 200 is a straightforward way of determining how “much house” you will be able to comfortably afford, based on your current monthly rental payments.
It is easy to remember, and easy to calculate – simply double your rent and add two zeros to the end.
The Rule of 200 doesn’t replace the existing affordability rules, but it will give you a better picture of which house will be most comfortable for first-time homebuyers, without inducing the anxiety of being “house poor”.
Want to Know More about Buying your First Home?
If you want more first time homebuyer tips, head over to my friends at DollarSprout to read 9 Simple Steps to Buying your First Home! Their article covers all the info you need. Not only all the money stuff, but also deciding where to live, finding an agent, submitting an offer, and moving in.
I spent a lot of time and effort developing the Rule of 200 for first-time homebuyers. If you would like to use the information presented here in your blog, website, print media or other, please reference Money In Your Tea and link back to this post.
Share this with friends who are potential first-time homebuyers! And let me know in the comments if it was helpful for you!