You found your dream home, but can you safely afford it? Before you commit to the biggest financial decision of your life, consider the 28/36 rule.
The rule is used by lenders to determine what you can afford, according to Ramit Sethi, best-selling author of “I Will Teach You to Be Rich.”
“It’s used by lenders, but it’s also a really helpful tool for us as individuals to decide how much debt we can afford,” Sethi tells NBC News.
The rule is simple. When considering a mortgage, make sure your:
- maximum household expenses won’t exceed 28 percent of your gross monthly income;
- total household debt doesn’t exceed more than 36 percent of your gross monthly income (known as your debt-to-income ratio).
In other words, if your maximum household expenses and total household debt are at or lower than 28/36, you should be able to safely afford the home.
TOTAL HOUSEHOLD EXPENSES
When calculating your household expenses, Sethi says to consider everything your mortgage will include: the principal, interest, taxes, and insurance, or PITI.
In total, your PITI should be less than 28 percent of your gross monthly income, according to Sethi.
For example, if you make $3,500 a month, your monthly mortgage should be no higher than $980, which would be 28 percent of your gross monthly income.
TOTAL DEBT
To determine your debt-to-income, calculate:
Dollar amount of monthly debt you owe divided by dollar amount of your gross monthly income.
For example, if you have $1,000 of monthly debt and make $3,500 a month, then your debt-to-income ratio would be .28.
In the above two scenarios, your household expenses vs debt is 28/28. This puts your household expenses at 28 percent and your debt under 36, which means you can safely afford the home.
“If you’re within those parameters, it’s a good rule of thumb that you’re fine,” says Sethi.
But let’s say 50 percent of your gross monthly income is going towards your total debt. “It tells you you’re outside the parameters and that’s a big red flag,” explains Sethi.
Be conservative
Many people buy a house because they fall in love with certain features like the bathroom faucets or hardwood floods, says Sethi. But the author insists you must stay focused on costs.
“Buying a house is probably the biggest financial purchase of your life, and you should be very financially fluent when it comes to making a purchase of this size,” he says.
Related
If you don’t truly understand what you can safely afford, he says, you may end up with a mortgage that will financially drain you. Many home buyers, he explains, get so excited about a house that they don’t think about how they might struggle to pay for it if they lose their job or come down with a major illness.
For that reason, he says to be conservative.
“Being conservative means you save up for a 20 percent down payment, being conservative means you take a straightforward 15 or 30-year loan, and it means that you calculate these basic numbers and know that you’re under the 28/36 rule very comfortably,” Sethi says.
What if you just don’t have enough for a down payment?
If you don’t have enough savings for a 20 percent down payment, then you need to keep saving, Sethi says. If you are struggling to save, he advises creating a sub-savings account.
A sub-savings account is an automated account that directly deposits small amounts from your paycheck into a savings account, so you don’t even have to think about it, he says.
“A lot of people say ‘Hey, I’m cut to the bone, I can’t really save,’” he says. “Well, it turns out when you automate this money you never even see it. It actually adds up pretty quick.”
And don’t underestimate the power of the side hustle, he says.
“A lot of times people underestimate the power of earning more through a side job, through a business, through negotiating your salary,” Sethi says.
“Don’t just give up,” Sethi added. “Start saving, pay off debt, and consider earning more. All three of those things will help you eventually buy a house if that’s what you choose to do.”
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As a seasoned financial expert with a comprehensive understanding of personal finance and mortgage matters, I bring a wealth of knowledge to the table. My expertise is deeply rooted in the principles of responsible financial management, particularly in the context of real estate and homeownership. I am well-versed in the intricacies of mortgage affordability and the critical considerations individuals must make before committing to such a significant financial decision.
Now, let's delve into the concepts outlined in the article you provided:
The 28/36 Rule
The 28/36 rule is a fundamental guideline used by lenders and individuals alike to assess mortgage affordability. It consists of two components:
-
28 Percent Rule: This dictates that the maximum household expenses, including principal, interest, taxes, and insurance (PITI), should not exceed 28 percent of your gross monthly income. This ensures that your housing costs are within a reasonable proportion of your overall income.
-
36 Percent Rule (Debt-to-Income Ratio): The total household debt, when expressed as a ratio of your gross monthly income, should not surpass 36 percent. This includes all debts, not just mortgage-related ones.
Calculating Mortgage Affordability
Total Household Expenses (28 Percent Rule)
- To calculate your maximum monthly mortgage payment under the 28 percent rule, multiply your gross monthly income by 0.28.
- Example: If your monthly income is $3,500, your PITI should be no higher than $980 (28% of $3,500).
Total Debt (36 Percent Rule)
- Determine your debt-to-income ratio by dividing the total monthly debt by your gross monthly income.
- Example: If you have $1,000 in monthly debt and earn $3,500, your debt-to-income ratio is 0.28 (28%).
Interpreting Results
- If your household expenses and total debt are at or below 28/36, it suggests that you can safely afford the home.
- Conversely, if a significant portion of your income (e.g., 50%) goes toward total debt, it raises a red flag, indicating potential financial strain.
Be Conservative
- Emphasizes the importance of financial prudence when purchasing a home.
- Recommends a 20 percent down payment, a straightforward 15 or 30-year loan, and adherence to the 28/36 rule for comfortable financial management.
Saving for a Down Payment
- Advocates saving for a 20 percent down payment.
- Introduces the concept of a sub-savings account to automate savings from paychecks.
- Highlights the potential impact of a side hustle in augmenting savings.
Conclusion
In conclusion, the 28/36 rule serves as a valuable tool for both lenders and individuals, offering a structured approach to assess mortgage affordability. Responsible financial practices, such as being conservative in decision-making, saving for a down payment, and exploring additional income streams, are essential elements in ensuring a sound financial footing when venturing into homeownership.
