Maybe you’ve heard of the 28/36 rule. If so, FORGET IT! According to this rule, households should spend no more than 28% of their gross income on home-related expenses which includes mortgage payments, home-owners insurance, property taxes, and any related association fees. And households should spend no more than 36% on all debt, which in addition to housing, includes such things as student loans, car loans and credit cards.
So, if your household gross income is $100,000 per year and follow the 28/36 rule, your housing expenses should not exceed $28,000 annually or about $2,333 per month. Your other personal debt servicing payments should not exceed $8,000 annually or $667 per month.
Using an effective tax rate of 20%, this 36% pre-tax figure is the same as 45% of after-tax income. Other financial experts would advise no more than 25% of after-tax (take home) income1. 25-45% is a pretty big range. Which is correct? Since a specific figure may not apply to everyone’s situation, let’s narrow this down a bit based upon your own circumstances.
Questions to Answer
How many months of emergency savings do you have? How much are you contributing to retirement? How much are you going to put down as a down payment? Then give yourself either 0, 1, or 2 points for each.
Emergency savings: <1 mon. (0 points); 1-2 mos. (1 pt); 3+ mos. (2 pts)
Retirement savings: <5% (0 points); 5-9% (1 pt); 10+% (2 pts)
Down payment: 0-9% (0 points); 10-19% (1 pt); 20+% (2 pts)
Here’s What You Can Afford
Add up your three points. 0-1 points – Don’t add any new debt. 2-3 points – You can support up to 25% of after-tax income. 4-5 points – Up to 30%. 6 points – Up to 35%
Now, you might be reading this and thinking “Uh oh! I’m already over Todd’s suggested debt level. What should I do now?” That is a GREAT question and the topic of my next article.
1 Dave Ramsey at https://www.daveramsey.com/blog/types-of-debt