Rule of Thumb For Reasonable Housing Costs?

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.

Lender Ratios
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.

Comments

  1. I the recent Economic and Housing Recovery Act, the homeowner bailout benefits are provided only to those whose mortgage payments exceed 31% of their gross income. That should tell you something about what is reasonable and what isn’t.

  2. But I don’t understand then, Jonathan. If Fannie Mae and Freddie Mac uses this conservative ratio when giving out mortgages — where are the sub-prime mortgages that are causing them to fail? Where did they come from? Are their conforming mortgages failing? Why?

  3. I ran the math.
    Im at 27/36 with my current debt… based on my net income.
    It has allowed us to make 1.5x-2x payments on our car loan, which should be completely paid off in 2.5 years (Feb 09).
    At that point our house payment will be our only debt – so we will be at about 15% of our gross. My car is 9 years old, so its days may be a bit numbered, but we have no plans to take on additional debt until we have to.
    15% of our income provides us with enough house to meet our needs, and then some. I think 20% would give us plenty of room for ourselves, two dogs, 2.1 kids, and a cat. These crazy %’s are either people who make little to no real income, or people wanting to live a life they cant afford.

  4. I’ve never understood why monthly debt payments seem to be of more importance than total debt in applying for mortgages. So if I have 3 car payments of $500 left, that’s counted against me in the same way as if I have 45 left?

    I ask because my monthly car payment is, in fact, fairly high (they offered me a .7% rate with a short term, and I put 0 down)… should I “transfer” the remainder to a credit card, which might have a monthly payment of only $200, via BT schemes before applying for a mortgage?

  5. ThePessimist says:

    Mimi – the Freddie and Fannie portfolios of mortgages have been doing okay. For both companies, the problem is that they bought a whole bunch of securities issued by other mortgage companies in order to goose their returns. The rules only apply to mortgages that the two companies buy, not mortgages backing securities that they buy.

    In effect, Fannie and Freddie were in two businesses: financing mortgages, and running a MBS hedge fund. You know how the Bear Stearns hedge funds went bust? Well, this is similar.

  6. And why didn’t you post this before April/2007? haha….i think we got our loan at about 40% ratio which, looking back, i wish we had been a bit smarter at. but that’s how you learn, right?

    on an interesting note, we also got 100% financing on an interest only loan (30 year fixed, with 20% of it a maxed out HELOC w/ variable rate), but i’m actually happy about that one! we’re forced to pay the minimum, but can knock away the principal at our leisure. and luckily we’re pretty good about that.

  7. Also, even if you start at conservative ratios and then your interest rate jumps so that your mortgage payment grows much more quickly than your gross income does, then you may no longer be at conservative ratios.

  8. question… what if you are buying a condo or townhouse, are HOAs included in the DTI calculation?

    Should they?

  9. Imtos – I believe the HOA fee is considered part of your housing obligation. From FHA:

    mortgage payment = (principal and interest; escrow deposits for real estate taxes, hazard insurance, the mortgage insurance premium, homeowners’ association dues, ground rent, special assessments, and payments for any acceptable secondary financing)

  10. My personal opinion is that this 28%/36% rule of thumb, like any other rule of thumb, is just that — and a handy rule, and not necessarily a hard and fast law. My personal ratio is about 45%. I bought about a year and a half ago. Unfortunately, in my area, there simply aren’t any houses (at least nice houses) for much cheaper than what I bought mine for. But here’s the thing: I have no other debt. My monthly non-housing-related bills total about $250. So even though I’m spending 45% on housing, I’m still saving ~20% or so. In addition, I’m also renting out some of the rooms, and I’m also saving any money I get from rent payments, on top of the other ~20%. I could easily make double payments and still have money left over.

    Can I afford my house? I sure think so.

  11. auntie_green says:

    Jeremy, agree with you on that 100%, it should be as you outlined.

    My 2 cents on ratios: it may seem like you’re spending every cent and only eating Kraft Mac N Cheese when you first buy, but if you get a fixed rate mortgage and don’t refi to take $$ out, in a few years, your payment will seem small….that’s my first hand experience.
    I know a lot of people really like interest only and/or adjustables but I love my 15 year fixed. Its perfect for me. Everything else goes up and up and up in price, my mortgage remains the same

  12. These limits make sense for a middle income earner. If you make around the median income for an area, you would be stupid to pay 40% of your income on a mortgage…you’d probably be hard pressed to live decently. But what if you earn 200K/year and you only need 30-40K to live on, why shouldn’t you be able to dedicate 100K of that to a nice house if that’s what you want to do. If your income is stable that’s no more risky than the person making 75K/year with the same living expenses dedicating 20k/year to his mortgage…

  13. It does seem that inflation would improve your income situation as time goes on with a fixed payment (assuming your income keeps up with inflation).

    That’s definitely a good thing to keep in mind.

  14. I’ve always heard of the 30% rule that you mentioned but I didn’t realize it worked quite that way. Thanks.

    Do they take equity into the equation? For example if you have 50% equity in the house but you’re over the 28% – does that impact the banks decision or is the ratio based purely on the numbers?

  15. I certainly remember discussing DTI ratios with my agent and loan broker when I purchased my first house a little over 10 years ago. It’s interesting to note that the subject never came up on the 2nd or 3rd house, even though I mentally used the DTI ratios to weed out houses that simply wouldn’t be appropriate for me from a cost standpoint (not to mention lifestyle standpoint).

    I actually use DTI ratios when placing tenants into my rental properties — some have never heard of them, so I had to include an example of how DTIs are computed in the application paperwork. As a screening tool I’ve found DTIs quite useful and I think it helps my tenants understand housing affordability as well.

  16. Jeff – sounds like a landlord with good business plan. Where do I invest?

    Our first mortgage we ignored what they offered and made a decision based on what we wanted for payments. We lived within that budget for 6 months before making our first offer. It was a bit tight, but we could manage it… its already gotten a bit easier and with any luck will continue to do so. We took the 5 year ARM to save a few % initially, but locked it in this year to avoid any changes now that we are over 4 years in.

  17. Lol… Not really a business plan, but a desire to provide a nice home for rent at an affordable price while at the same time not having to worry about whether or not my tenants will pay the rent. I’ve never had a tenant miss a payment, and in fact, there’s only been one late payment in 8 years.

    I’m keeping my eyes open for another property, but prices need to come down more in my area before it makes financial sense (when compared to other investments, adjusted for risk).

    As far as mortgages are concerned, my last one (for the house I live in now) was a 3/1 ARM 4.25% which I paid off about a month before the first adjustment — peace of mind living 100% debt free…

  18. Uncommonadvice says:

    The DTIR (Debt to income ratio) has never really caught on in the UK. Banks don’t reveal how much they will lend but it’s pretty much still along the old “income multiple” lines. For example, if you earn £20,000 you’ll get a mortgage of £80,000 etc.

  19. The same concept should be applied to rent ratios. For instance, I always kept my rent below 25% Gross Income. I see many people paying up to 40% GI on rent…what’s up with that???

  20. As I said earlier, 40% is not really that high. I have take-home pay of $2700/month, and my house payment is $1185/month. That is a ratio of 43%. When I bought the house, I was making even less, so the ratio was even higher — about 50%. However, I rent out two rooms for a total of $700 in income a month. And my other bills total about $300 a month or so. So most months I am able to save approximately $1500.

    I repeat. Can I afford my house? I sure think so.

  21. Sometimes it’s just not feasible to keep it under 28% – the average rent in my neighborhood for a 1BR is somewhere aroud $3000…the average income is *way* under 10k/month…

    NYC breaks all the rules…

  22. Enzo — that’s precisely what I’m doing… Using DTI to estimate affordability for my prospective tenants. They’re a reasonable approximation and give me quantifiable criteria which avoids even the potential for problems under the equal housing act. It also has the nice effect that when a tenant leaves my property, they’re usually ready to buy a house and do so responsibly. In fact, I believe all of my former tenants are now home owners (yes, they actually keep in touch).

    Probably 90%+ of the people who look at my properties don’t qualify based on the DTI criteria alone. I price aggressively, so I get a ton of traffic (hence I do open house showings rather than private showings). I’ve never had a property vacant for more than 2 weeks unless I wanted it vacant while I was doing work.

    As for those who have 40% of their gross income tied up in rent — it’s not a recipe for success. Some people can make it work, but most can’t in the long run. It’s also a red flag that their overall money management skills may be lacking — I don’t want to be the landlord who doesn’t get the rent because a tenant was running so close to the edge that when a minor financial bump hits their entire financial situation fall apart.

    Rick — we’re discussing DTI, which typically uses gross income, not net (take-home) income.

    Jeff

  23. Perhaps a more important question to ask is what percentage of your net worth should be in your house? If you have a lot of cash and can buy a house outright you’ll certainly be spending less than 30% of your income each month on housing, but does that make sense? With housing prices going down having a lot of money tied up in your house may not be the best idea, but it still may be less risky than other investments.

    People’s thoughts?

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