My wife and I have recently been discussing purchasing a home, and in the process have become a little sticker-shocked over the local housing prices. The target amount we had in our head doesn’t translate to enough house for our family, so I went back to the drawing board to determine how much house we could afford.
I found out that mortgage lenders have their own set of rules, but if followed could leave you house poor. After running the numbers, I’m starting to think there is nothing wrong with renting a house indefinitely!
The 28/36 ratio – the 28% rule. Mortgage lenders would like for your new housing payment, including taxes and insurance, to be less than 28% of your gross monthly income. That means a family earning $50,000 a year should not spend more than $1,167 on housing. That number seems a bit high to me, considering after taxes that family is probably only bringing home around $3,300 a month. When you back out other payroll deductions such as health insurance, FSA contributions, etc. that doesn’t leave much disposable income after an $1,100 mortgage payment.
- Frugal Dad’s Rule: A more conservative ratio of around 20% of monthly gross income going to housing costs would leave a larger cushion.
The 28/36 ratio – the 36% rule. In addition to the 28% rule, mortgage lenders also use a 36% debt-income ratio based on monthly income and debt expenses. Using our same $50,000 a year family as before, their total debt payments each month (including the new mortgage) should not exceed 36% of their monthly gross income, or $4,167. If our family fully maximized the 28% rule and took out an $1,100 mortgage that would only leave $400 in additional allowable debt payments to stay under the 36% rule. A couple credit card payments and/or a significant car payment could easily push them over the 36% rule.
- Frugal Dad’s Rule: In this case I actually like to use the mortgage lenders 28% rule for the total amount of debt you should carry, including your house payment. Revising the 36% debt-income ratio down to 28% forces you to either look for a much cheaper home, save up for a larger down payment, or become debt free before buying a home. In either case, you will have more money left over each month to finance your remaining financial goals by following Frugal Dad’s maximum mortgage calculator.