When calculating your monthly budget, housing is often one of the biggest expenses. Conventional wisdom says that you shouldn’t spend more than 30% of your gross income on housing, including rent and utilities for renters, or a mortgage payment with interest and taxes as well as maintenance for homeowners. Based on a formula developed by the U.S. government in 1981, the 30% guideline is designed to prevent people from becoming overburdened by their spending on housing. The premise was that people could spend 30% of their income on housing and still have enough discretionary income left for other expenses.
However, an increasing number of mortgage lenders view this recommendation as outdated, and opt for a more generous 43% as the threshold for a housing budget. Today’s consumers spend their money differently today than they did 40 years ago, when 401(k) plans and student loans weren’t as common. Not to mention, the 30% rule doesn’t account for different situations, income brackets, real estate markets, and other variables. For instance, a home buyer with little or no debt can likely afford a much higher mortgage payment than someone with thousands of dollars of debt.
The question remains then: How much should you spend on your housing?
The answer is: it depends.
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Percentage of Income for Housing: What to Budget
Financial experts use a few different rules of thumb to determine what percentage of income should go to housing. Although these formulas are designed to help people develop working budgets to achieve financial success and avoid getting in over their heads, they aren’t always realistic or achievable when you look at real salaries and real expenses. Nevertheless, they represent a starting point.
The 50/30/20 Rule is a simple plan developed by Massachusetts Senator Elizabeth Warren and her daughter, Amelia Warren Tyagi. The plan recommends calculating your budget based on your net income (what you bring home after taxes) and dicing your expenses into three categories: 50% Needs, 30% Wants and 20% Savings and Debt Payments. The “needs” category includes housing, utilities, food, insurance, car payments, minimum student loan, and credit card payments, and anything else that is an absolute necessity. The “wants” category includes any spending on other items, such as vacation, hobbies or dining out. The remaining 20% should go toward adding to your savings and paying down debts, such as student loans and credit cards.
The 50/30/20 budget plan is popular because it simplifies budgeting. However, there are some flaws in the plan. The major flaw is defining “need.” Obviously, housing and food are needs — but what about clothing? Or an unlimited texting plan? And does cable TV count as a utility or a want? The 50/30/20 plan lacks room for these nuances, making it more difficult to calculate your budget. It also doesn’t account for differences in salaries and location. For example, living in an urban area is typically more expensive than suburban or rural areas, making it unrealistic to squeeze all of the “needs” into 50% of your take-home pay. And for people who are paid hourly, or otherwise have fluctuations in income, such rigid percentages may not be attainable.
28/36 Rule aka 43 Percent Rule
The 50/30/20 plan may be useful for helping you develop a framework for your budget, but most mortgage lenders use a different formula for determining how much you qualify for when seeking a home loan.
With the 28/36 Rule, mortgage lenders base your qualification on your gross income — income before taxes — and how much debt you have. Under these guidelines, the percent of income for a mortgage should not be more than 28% of your gross income, and your total debt payments, including the mortgage, car payments, etc. should not be more than 36%. The guideline is designed to prevent individuals from taking on more debt than they can handle, thereby reducing the risk of defaulting on the loan.
The 28/36 Rule is considered the ideal, and mortgage lenders have different policies and the ability to offer some leeway depending on the individual situation. That being said, the 28/36 rule is often used in conjunction with the 43 Percent Rule. The 43 Percent Rule basically means that if your debt-to-income ratio is higher than 43%, you are unlikely to qualify for a loan, as you’re taking on too much debt and are more likely to default. For example, assume that you bring home $4000 per month. The house you want to buy has a $1500 per month payment. You also have a $400 car payment and a $300 credit card payment. Your total debt is $2200 per month. When you divide that debt by your income ($2200/$4000) your debt to income ratio is 55%, and most lenders will deny your application.
Using the 28/36 rule to determine your monthly budget and how much to spend on housing can be useful when you are trying to purchase a home, as it puts you into a position to meet lender expectations. It’s also never a bad idea to reduce your debt, and maintain as low a debt-to-income ratio as possible. Again, though, this guideline does not take into account all possible scenarios; for instance, you may only have a few payments left on your car, which will then reduce your debt burden.
What Costs Should Be Considered in the Housing Budget?
Regardless of the formula you use to determine your housing budget and what percentage of income should go to rent or mortgage, be sure you include all of the expenses that contribute to the monthly cost. These may include:
- Rent or mortgage;
- Property taxes;
- Homeowner’s or renter’s insurance;
- HOA fees;
- Utilities (Electric, Gas, Water & Sewer; Cable or Satellite, Internet, and telephone if necessary);
- Maintenance (Pest control, lawn care, snow removal).
Some people opt to include savings for home repairs into their monthly housing budget as well. Including extra funds to cover the repair or replacement of appliances, pay for plumbing services, or for other emergencies is never a bad idea, but whether you include it in your housing budget or savings budget is up to you.
Saving Money on Rent or Housing
If you determine that you are spending more on housing than you should be, look for ways to reduce your expenditures and get your budget on track. Some ways you can save money might include:
- Downsizing your home. Consider whether you’re using all of the space in your house or apartment and if you can get by with a smaller place.
- Getting a roommate. If you have the space, letting someone else move in and share the costs can ease the strain on your wallet.
- Rethink amenities. Are you paying huge HOA or amenity fees every month to live in a building or neighborhood with a pool, clubhouse, gym, etc.? Do you use those amenities? If you don’t, consider whether it makes sense to move to a less expensive place with fewer amenities. If moving isn’t an option, start making use of what you’re paying for. There’s no sense in paying for a separate gym membership when you can work out in your building.
- Reconsider wants and needs. Do you really need unlimited data on your phone, or three different streaming services? Can you survive without cable TV? Look closely at your spending, and see where you can recategorize expenditures to save money.
- Comparison shop. Do your homework on insurance policies, utility plans, and other housing expenses to see where you can find a better deal. Check your insurance coverage annually to be sure you aren’t spending more than necessary.
- Consider refinancing. If you own your home, refinancing your mortgage at a lower interest rate can potentially save thousands of dollars.
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