The Simple Dollar is running a series in which we re-evaluate Money Magazine’s “25 Rules To Grow Rich By”. One “rule” will be re-evaluated each weekday until the series concludes; you can keep tabs on the action at the 25 Rules index.
Rule #4: Your total housing payments should not exceed 28% of your gross income. Total debt payments should come in under 36%.
This is an unsurprising rule that is basically just a statement of the basic rule of thumb most lenders used when deciding on a home loan and is just a rewrite of yesterday’s nearly-identical bromide. But the fact is that this rule isn’t really hard and fast, either.
In fact, for most people 28% is beyond what they should realistically budget for while allowing themselves any room whatsoever to breathe. If you spend 28% on your mortgage payment alone, you’ve committed nearly 40% of your gross wages to your house payments, your property taxes, your insurance, and necessary upkeep, which puts many people on a path where they simply cannot afford to save any money whatsoever, since other taxes will claim another 25%, leaving you about 35% of your income to live on.
Here’s a better rule: figure this number in terms of your net income. This way, you can calculate how it will directly affect your monthly take-home after you’ve removed items such as your income tax withholdings and your retirement payments, which you should never touch just to buy a home. Figuring that you’re working with 28% of your gross income, let’s assume that you can potentially spend 35% of your net income on housing. Since you should be contributing, at a bare minimum, 5% of your net income into some sort of savings or investment in the event of the loss of your employment, this leaves 30% of your take-home pay that you can spend on housing. You can do a similar calculation and quickly determine that your total debt repayment shouldn’t exceed 40% of your net income. So let’s rewrite the rule:
Rewritten Rule #4: Your total housing payment should not exceed 30% of your net income. Total debt payments should not exceed 40% of your net income.