When shopping around for a home, one of the first questions you should ask yourself is how much house you can afford. Understanding whether or not you can afford a specific mortgage payment — and the rest of the costs that come with home ownership — is a necessary part of the process. Make sure you don’t put this off until it’s too late. It’s crucial to figure out the answer in order to avoid disappointment — or major financial stress — in the future. After all, houses can be emotional purchases. You don’t want to start touring houses that are out of your price range. Those higher priced homes will almost always seem more desirable. However, they will quickly strain your budget to its breaking point. Are you thinking about buying a house in the near future? Let’s explore one of the most popular rules related to home affordability — the 30% rule.
What is the 30% Rule?
The 30% rule states that you shouldn’t pay more than 30% of your monthly income for your mortgage. You should also lump in home insurance and property taxes into this amount. Those payments are part of the housing costs that really can’t be avoided.
Various interpretations of this rule exist. However, it’s commonly accepted that the rule applies to your after-tax income. It also applies to all of the items that go into your mortgage payment. Let’s say your property tax and home insurance premiums are all lumped in with your mortgage principal and interest. Now assume you make you make $6,000 a month, after taxes. The 30% rule says you don’t want to pay more than $1,800 a month for your monthly payment. (Thirty percent of six grand is $1,800, if you’re bad at mental math.)
If you normally pay you home insurance premiums and property taxes in an annual lump sum, you can still include them in the 30% rule. Just divide those annual payments by 12 and include the number in your calculations.
Does the 30% Rule Make Sense?
Personally, I’m not a huge fan of the 30% rule. I think close to a third of your income going towards your home payment is probably a bit steep. Depending on where you live, though, you might not have an option. In some areas, you might be lucky to keep it to 50% of your income. However, if you’re in that scenario, you should probably consider an area with a lower cost of living.
I also think you should put all of your housing costs into the equation. So add in your average monthly utility costs too. You should also factor in a cost for average annual maintenance or one-off repairs. You house may need a new roof every 15-to-20 years. Or a new appliance if an old one kicks the bucket. When you add those expenses to the mix, you’ll have even less to spend on your mortgage payment. That is, if you’re sticking to the 30% rule.
Don’t forget that a fixed percentage rule doesn’t account for income that might vary a great deal. For example, if you freelance or earn a portion of your income from sales commissions, your monthly income might swing up and down from month to month. That means calculating a 30% rule is a lot harder.
The 30% rule also starts to lose its purpose as your income increases. On the one hand, someone with low income may not be able to afford anything else if they use 30% of their income on a mortgage. On the other, someone who has a very high income might be able to afford to spend 50% on housing costs, while still easily being able to afford the rest of their expenses.
Here’s a quick example. Joe makes $2,100 a month after taxes and spends $700 on a mortgage. That’s 30% spent on mortgage payments, so he has $1,400 left to make ends meet each month. Jane, on the other hand, makes $30,000 a month. She spends $15,000 on her huge mansion. That’s 50%, which smashes the 30% rule pretty badly. However, she still has $15,000 every month to spend on everything else. You can probably see the differences in when the 30% rule makes sense — and when it doesn’t.
What are YOU Comfortable With?
Ultimately, it has to be about what you are comfortable with in your own finances. Personally, my housing costs are under 20% of my monthly income. I can stay comfortable with my housing costs hovering that 20% mark. We were actually closer to the 30% mark when I bought my first house. I wasn’t very comfortable with that at all. It made budgeting for anything else quite tricky.
When deciding how much of your income should go towards housing expenses, it’s important to consider your own situation. It’s also worth thinking about what would happen if your situation changed. How stable is your job? Are you the sole breadwinner in the house? Or if there another income to rely on? Do you have multiple income streams? What will your finances look like if you (or your spouse) was laid off?
Although my wife and I have an investment portfolio that throws off income regularly, I’m ultimately self-employed. My income isn’t as stable as someone with a traditional 9-to-5 job. I didn’t want a potential loss in business income to put my house payment in jeopardy. As a result, I like to keep those expenses under 20%. I am happier now that it’s dropped even further. That way, my family will never have to move if my income inevitably fluctuates.
My sister, on the other hand, lives in a high cost of living city. She has a very stable job. She is also on the fast track to climb the corporate ladder, with outsized raises every year. I’m not privy to all her financial details, but it’s safe to assume that her housing payments were well over 30% of her salary. However, after a few years of promotions and raises, that percentage is quickly dropping.
The Bottom Line
When buying a house, carefully consider your individual situation. Then think about what you would be able to handle if you ended up with a financial setback. Do you have a backup plan? That should be your guide to how much house you can afford. As for the 30% rule, it’s not just a handy calculation for you to do yourself. When you apply for a mortgage, most lenders will also use the 30% rule as a way to judge your overall financial decision. As potential lenders analyze your entire finances, they may reject your mortgage application if it looks like you’re going to be spending more than 30% of your monthly income on your new home. If that happens, you only have two choices: find a way to make more money or start shopping for a cheaper house.