Are you dreaming of becoming a homeowner? One of the first things prospective homebuyers ponder is how expensive of a home they can afford.
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Determining how much you should pay monthly for your mortgage can often be challenging, especially if you have other debt payments or expenses. However, there is one easy rule to follow.
The 28/36 rule says your total housing costs should not exceed 28% of your gross income, and your total debt shouldn’t exceed 36%. But what does this mean exactly, and how does the rule work in practice? Let’s break it down.
How the 28/36 Rule Works
This rule is basically designed to help ensure you’re not taking on too much debt by looking at your debt-to-income ratio or the amount of debt you have about your income.
So, what exactly are housing expenses? These include the mortgage payment, including principal and interest, homeowners insurance premiums, property taxes, private mortgage insurance (if applicable), and HOA fees (if applicable). According to the rule, all these expenses combined shouldn’t exceed 28% of your income.
Regarding total debt, you’ll also factor in things like credit card balances, auto loans, student loans, personal loans, and more. These, in total, should be at most 36% of your gross income.
While your housing payments (including mortgage and rent) are often one of your most significant recurring expenses, you probably have other necessary things you pay for, like groceries or utilities. If too much of your income is going towards paying off debt, you have less money to put towards those expenses and other savings goals. You also could be at a higher risk of defaulting on your loans.
Some mortgage lenders actually use the debt-to-income ratio when deciding if they should approve you for a mortgage.
The 28/36 rule isn’t a strict guideline and can be flexible based on your personal situation. But using it as a benchmark when figuring out how much home you can afford can help ensure you’re not taking on more debt than you can handle.
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Calculating How Much Home You Can Afford
The first thing you want to do when figuring out a reasonable home budget is to calculate your household’s gross monthly income. For full-time, W-2 workers with no other sources of income, this should be pretty easy — take your annual salary before any deductions or taxes.
You may need to add everything together for freelancers or those with multiple income streams. While your income may fluctuate throughout the year, making it more difficult to predict gross income, try to determine a monthly average and multiply that by 12 to get your projected gross income.
Once you have your gross income, multiply that by 0.28 to find the maximum amount you should spend on housing, including your mortgage, taxes, and insurance. You’ll also multiply your gross income by 0.36 to find the maximum amount you should spend on debt.
If you don’t have any additional debt, you can potentially take on a higher mortgage payment, above 28% and up to 36% of your gross income. If you have high amounts of existing debt, you may need to lower your potential housing payments below 28% of your income.
Let’s take a look at how this rule works in practice. Consider a couple, each making $60,000, for a total gross income of $120,000 annually (or $10,000 per month). According to the 28/36 rule, they shouldn’t spend more than $2,800 on housing monthly and $3,600 on total debt payments.
If the couple’s monthly debt were $2,000, they’d need to consider a housing payment of $1,600 or less to stay within the 28/36 rule. But if they had no existing debt, they could consider taking on a housing payment above $2,800 (below $3,600) to comply with the rule.
Making the 28/36 Rule Work for You
If you’re hoping to take on a mortgage paying outside of the 28/36 range, there are a few things you can do:
- Put a larger down payment: Many lenders require as little as 3.5% (or, in some cases, 0%) of the home’s purchase price as a down payment, but you should consider putting down much more, especially if you want to lower your total monthly housing cost. Putting down at least 20% will help you avoid private mortgage insurance and reduce the overall mortgage’s size, lowering your monthly payments.
- Shop around for a lower interest rate: Interest rates can cause your mortgage payments to balloon. Comparing lenders to find the best (and hopefully lowest) option can lower your monthly costs and help you save over the lifetime of your loan.
- Build your savings: Building a large cash reserve can cover you if you find yourself unable to meet your debt obligations in a given month. While most experts recommend saving between three to six months’ worth of expenses as an emergency fund, you may want to consider saving more.
- Pay down debt: Paying off high-interest debt like credit cards and personal loans can free up more funds for other obligations, like housing.
But just because your housing payments can reach up to 28% of your income doesn’t mean they should. Mortgage payments are often very lengthy (lasting between 15-30 years), and your circumstances may change throughout that time.
For example, you may lose your job or experience a medical event. Having a robust emergency fund is important, but it’s also helpful to take a conservative approach to figuring out how much home you can afford.
At the end of the day, it’s really up to you and your personal financial decision. Some people may be more comfortable taking on debt than others. But following a simple guideline like the 28/36 rule can help you better estimate what’s feasible.
That way, you can go into the home-buying process feeling confident in getting approved for a mortgage and you’re searching for houses within your budget.
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This article originally appeared on GOBankingRates.com: How Much Home Can You Afford? Use the 28/36 Rule To Find Out
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