Whether you're looking to rent or own your next home, Kevin O'Leary says there's an easy way to determine how much you can afford to pay.
The judge of CNBC's "Money Court" tells CNBC Make It that renters and buyers alike need to follow the 1/3 rule, which calls for a third of your after-tax income to go toward living expenses, a third toward your home and the last third toward savings and investments.
That means that a person earning $3,000 a month after taxes shouldn't spend more than $1,000 on housing.
"If you let the house that you're buying's mortgage payment or the place you're renting be more than a third of your after-tax cash flow, you're going to put tremendous stress on yourself," O'Leary says. "That means you may have to live in a smaller apartment if you're renting, or buy a smaller home to start."
O'Leary's advice is similar to the general rule that dictates you should spend no more than 30% of your gross monthly income on housing. However, his recommendation allocates a slightly higher percentage and uses post-tax income. The government has recommended that people spend no more than 30% on housing costs since 1981, and considers people who spend more "cost burdened."
For renters, that 30% includes rent and utility costs like heat, water and electricity, CNBC Make It previously reported. For homeowners, that figure includes homeowners insurance, as well as property taxes, utilities and your mortgage.
In expensive cities with high rent prices, O'Leary admits that it may be difficult to stick to the "one third-one third-one third" rule. If you're planning to buy a home, it's better to be patient and wait for one within your budget than to spend more than you can afford, he says.
"There's nothing wrong with buying a smaller home, living there for five years, selling it and buying a bigger home as your income goes up or you get married and you have two incomes," he says.
Aspiring homeowners should also be conscious of the the 28/36 rule, which stipulates that your housing expenses shouldn't exceed 28% of your gross monthly income while your total debt, including credit cards and student loans, shouldn't exceed 36% of your monthly income.
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Determining affordability in real estate involves more than just gauging your income against housing costs. It's a complex interplay of financial principles and guidelines. I'm well-versed in this field, having studied and advised on personal finance and real estate extensively.
The concept of allocating a certain portion of your income to housing costs is fundamental. Kevin O'Leary's 1/3 rule, advising a third of after-tax income towards living expenses, housing, and savings/investments, mirrors the classic 30% guideline but accounts for post-tax income. This rule aims to prevent overcommitting financially, ensuring a balance between living comfortably and saving for the future.
O'Leary's suggestion aligns with long-standing government recommendations, dating back to 1981, advising individuals not to exceed 30% of their gross income on housing. This 30% includes various housing-related expenses like rent, utilities, insurance, property taxes, and mortgage payments.
While O'Leary acknowledges the challenge, especially in costly urban areas, he emphasizes the prudence of waiting for a more affordable option rather than stretching beyond one's means. His advice advocates for starting smaller and gradually upgrading based on income growth or life changes like marriage.
Additionally, the 28/36 rule is a crucial guideline for aspiring homeowners, suggesting that housing expenses should not surpass 28% of gross monthly income while total debt, including credit cards and loans, should not exceed 36%. This rule helps in assessing the overall financial health before taking on a mortgage.
Understanding these principles helps individuals make informed decisions about renting or buying homes, ensuring financial stability while meeting housing needs.
