A lot of people need guidelines in life to help them know whether or not they are doing what they are supposed to do. Or put another way, the way that will help them be successful. The 25% rule is one that many of the financial experts use. But where does it actually come from? And is it correct?
We all know that banks are in the business of lending money. And one of the safest bets they can make is lending money on a single family home with a qualified buyer.
And how do they determine who a qualified buyer is?
They use the 28/36 debt to income ratio.
The “28/36 rule” or the “debt-to-income ratio” is a financial guideline used by lenders to determine whether a borrower can afford to repay a loan. The rule states that a borrower should not spend more than 28% of their gross monthly income on housing expenses and no more than 36% of their gross monthly income on total debt, including housing expenses, car loans, credit card debt, and other loans.
For example, if a borrower’s gross monthly income is $5,000, their housing expenses, including mortgage or rent, property taxes, and insurance, should not exceed $1,400 per month, or 28% of their gross monthly income. Similarly, their total debt, including housing expenses, should not exceed $1,800 per month, or 36% of their gross monthly income.
Lenders use the 28/36 rule to assess a borrower’s ability to manage their debt and make timely payments. By limiting the amount of debt that a borrower can take on relative to their income, lenders aim to reduce the risk of default and ensure that borrowers can afford to repay their loans.
It’s important to note that the 28/36 rule is just a guideline, and individual lenders may have their own standards for determining a borrower’s ability to repay a loan. Additionally, borrowers should also consider their own financial situation and long-term financial goals when deciding how much debt they can afford to take on.
Keep in mind banks do not want to have to take a home back when a loan gets defaulted on. They do it, but they would prefer not to. They aren’t in the real estate industry they are in the banking industry. They make money on lending money. So they want to make sure they reduce as much risk as possible when lending money on a house.
If the banks use 28%, then why am I suggesting 25%. Honestly, you can use either one, but I am more conservative than most, so the 3% less to me just helps you. Plus 25% is easier to remember.
Is the 25% rule a good gauge if you rent as well? It can be. However, I suggest that you make your decisions based more on your savings rate, your financial goals, and your overall lifestyle versus anything else.
As a renter myself, our monthly housing expense is less than 10% of our income on a monthly basis. It allows us to live the lifestyle that we want and it also allows us to pursue other investments. But our decision to rent is truly a lifestyle play for us.
We could buy something that would provide us a similar lifestyle, but the upfront costs to do so, make it a bad investment based on our goals.
I highly encourage you before you make a decision to buy a house or rent, you should determine what your financial goals are. And then make your decisions based on your goals.
To your success and your future.
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