What is the 28/36 Rule?

A practical technique for calculating how much debt an individual or household should take on is the 28/36 rule. According to this guideline, a family should spend no more than 28% of their gross monthly income on total housing expenses and no more than 36% on total debt servicing, which includes housing bills as well as other loans like credit cards and auto loans repayments. This rule is frequently used by lenders to decide whether or not to offer borrowers credit.

Better Understanding

You shouldn't spend more than 28% of your income on housing and 36% of your income on total debt/housing payments, according to the front-end ratio, often known as the 28/36 rule (known as the back-end ratio). This is a general guideline for a safe calculation of an estimate of whether you can buy a particular home or rent an apartment and how much debt you can afford.

Talking about mortgage payments is quite essential when discussing the 28/36 Rule. It also applies to rent payments since you can use this in both instances to figure out how much of your monthly income you have committed to paying out to others. When evaluating a borrower's credit using the 28/36 rule, lenders may ask about housing costs and comprehensive debt accounts in the credit application. In the course of its underwriting program, each lender establishes requirements for housing debt and/or overall debt. This indicates that payments for living expenses, typically rent or mortgage, cannot exceed 28% of the monthly or yearly income. The entire debt obligation cannot be higher than 36% of revenue.

Example

Pre-tax income is the foundation of the 28/36 rule. Let's take the example of earning $60,000. Pre-tax earnings equal $5,000 per month. According to the 28-36 guidelines, you shouldn't spend more than $1,800 per month on housing and debt combined. Let's say you pay $1,200 per month to rent an apartment. The remaining $600 per month can be planned for servicing all other debt.

Readers should be aware that when they purchase property, their monthly payments also include escrowed insurance, tax payments, and any homeowners' association (HOA) dues. This is in addition to the mortgage and interest payments. This typically means your housing costs will be much greater each month than the mortgage alone.

Finally, one should only consider solid, recurring payments when creating a 28/36 budget. This rule's objective is to contrast the money you can depend on (income) with the money you have committed to (debt and housing payments). Although they are vital, other line items like utilities and food expenditures are not noticed much because you usually have control over them in a way that you do not have with a mortgage or credit card payment. The same is reflected on the ledger's income side as well. One must never assess the ratios using erratic or uncertain income sources.

The 28/36 Rule in Use

The total amount of debt is where the 28/36 rule should begin. You shouldn't spend more than 36% of your total pre-tax income on housing and debt, according to this rule. Additionally, abiding by this rule will keep you from having a lot of houses but little money. One of the most serious mistakes new home buyers make is to believe that they can sell and earn through property deals by marketing their new home.

For some, this rule can entail becoming enthusiastic about the home they desire. Others can persuade themselves that buying a new house is an investment and that the future costs will eventually pay for their needs. However, once you get there (buy a new home), this is referred to as being cost-burdened. It indicates that you are constrained by inevitable monthly expenses that limit your capacity to save, consume, and go about your everyday business.

You can lessen the financial impact of the cost of your home by keeping it to 28% of your gross income. For buyers, this is particularly crucial. Cost-burdened tenants have the option of leaving at the end of their term. However, buyers who become cost-burdened must attempt to sell their home, which isn't always straightforward if they have spent too much for it.

Additionally, many lenders use this criterion when determining your creditworthiness. Many lenders consider your debt-to-income ratio in addition to your credit score, which means they think your debt load is related to your pre-tax income. If your monthly debt payments exceed one-third of your pre-tax monthly income, many lenders would consider this ratio to be excessively high. In such a case, it may be difficult for lenders to offer you loan services.

It's also critical to recognize that many teenagers find it difficult, if not impossible, to follow this guideline. With interest rates around 6%, the typical household college debt for adults under 40 is between $38,000 and $40,000. Particularly for graduates of professional schools who can receive pay-outs much above $1,000 per month, this can frequently make it hard to sustain a financial flow by the 28/36 rule.

Alternative Versions of the 28/36 Rule

Don't give up if you can't pass the 28/36 test because of your debt load. A few things are exceptions.

If other aspects of your financial profile are excellent, a lender can accept your application. Perhaps you have a high credit score or a down payment of over 20%. With larger debt-to-income ratios, you can still be taken at a higher interest rate than you otherwise would.

The 28/36 rule mainly pertains to conforming mortgages, so keep that in mind. If you qualify for a government-backed mortgage through the FHA (Federal Housing Administration), VA (Veterans Affairs), or USDA (U.S. Department of Agriculture), a lender might approve your application with a higher ratio.

More freedom is available with a government-backed mortgage (VA loans don't take front-end ratios into account at all). Just think about whether you are qualified for and satisfied with the terms of a government-backed mortgage.

The Bottom Line

The existence of the 28/36 rule is proof that we tend to overspend, and that's exactly the kind of financial safety net we need. According to the guideline, consumers shouldn't spend more than 28% of their gross monthly income on housing, whether a mortgage or rent, and the sum of all their expenses, including housing, shouldn't be more than 36%.