In an earlier post on motivating myself to work harder, I had thrown out a piece of “common” financial advice:
Spend less than 30% of income on housing.
It was really just an afterthought, but I got a bunch of e-mails about it. Where did you get this? Why 30%? Is that gross income or after taxes?
The source of this “rule of thumb”, which is about as useful (or useless!) as most such rules, is the traditional underwriting requirements of mortgage lenders. You know, before many of them went nuts.
Also called the debt-to-income (DTI) ratio, this is the maximum debt load that the lender will accept and still lend you money. You have two types of debt. Housing debt, which usually means PITI, or principal + interest + taxes + insurance, so it’s a bit more than just the straight payment from a mortgage calculator. The “other debt” is the sum of your other recurring monthly liabilities – car loans, credit card balances, student loan payments.
There are usually two lender ratios, a front and a back (Example: 28%/36%). The front ratio meant housing debt divided by gross income. The back ratio was housing + other debt divided by gross income. Usually you have to satisfy both of these ratios.
Some superficial online searching reveals that Fannie Mae and Freddie Mac allow a maximum of 28% for the front ratio and 36% for the back ratio. FHA loans have ratios of 29% and 41%. So that’s where my 30% number came from. Of course, even earlier this year you could find people allowing front ratios of 50-60%.
So if your gross income was $4,000 a month, to get a conforming Fannie Mae loan your housing payment should be no more than $1,120 per month. At the same time, your housing + other debt obligations altogether should be below $1,440 per month.