What is the 28/36 Rule for Mortgages?
The 28/36 rule is a guideline for the debt-to-income (DTI) ratio that buyers can use to avoid overextending themselves financially. Mortgage companies use this rule to decide whether to approve your mortgage application. In this article, we will explore how the 28/36 rule works, what it includes and excludes, as well as ideal calculations and some precautions when using this rule.
How Does the 28/36 Rule Work?
Are you wondering how mortgage companies use the 28/36 rule to determine how much money you can be lent? Let’s say you earn $6,000 a month, before taxes or other deductions from your salary. The rule states that your monthly mortgage payment should not exceed $1,680 ($6,000 × 28%), and your total monthly debt payments, including housing costs, should not exceed $2,160 ($6,000 × 36%). A mortgage company might use this amount as a forward-looking view of your ability to afford the monthly mortgage payment in the near future.
How to Calculate the Debt-to-Income (DTI) Ratio
Calculating the debt-to-income (DTI) ratio is not difficult. The first step you need to take is to determine your total monthly income – that is, your income before tax deductions and other expenses. If you are married and applying for a home loan with your partner, you should combine your incomes.
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Then, multiply your total income by 0.28, and then by 0.36, or 0.43 if you are aiming for a qualified loan. For example, if you and your partner have a total monthly income of $7,000, it breaks down as follows:
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$7,000 × 0.28 = $1,960
$7,000 × 0.36 = $2,520
$7,000 × 0.43 = $3,010
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This means that your mortgage, taxes, and insurance payments should not exceed $1,960 per month, and your total monthly debt payments – including that $1,960 – should not exceed $2,520.
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Unfortunately, the rule states that both monthly payments must be considered. Therefore, the next step is to find out the impact of your other debts. Add up the total monthly payments for non-housing debt, such as credit card payments, student loans, and car loans.
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For instance, let’s say your monthly debt payments total $950. Subtract this amount from $2,520, and you will see that your monthly mortgage payment should not exceed $1,570.
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Since you have relatively high non-housing monthly debts in this example, you are limited to $1,570 for housing loans, taxes, and insurance on your new home. In contrast, if you only had $500 a month in non-housing debt payments, you could allocate the full $1,960 to your mortgage payment, as $1,960 + $500 = $2,460, which is less than the 36% rule of $2,520 for total monthly debt payments.
Why Does the 28/36 Rule Generally Work?
The 28/36 rule provides a good guideline for lenders to determine how much home you can comfortably afford.
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“As a mortgage lender, one of our jobs is to assess risk, and the 28/36 rule is a big part of that,” said Edelstein. “You can be approved for a mortgage with ratios higher than 28/36, even up to 50% on the back end. However, the risks increase, and to qualify for higher ratios, you must have a strong credit history and make a larger down payment.”
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What counts towards your debt-to-income ratio regarding your monthly debt obligations? Any of the following payments can be included in your debt-to-income ratio:
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Future mortgage payment
Credit cards
Student loans
Car loans
Personal loans
Child support and alimony payments
Loans you co-signed for with others
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Note: Debt-to-income ratio does not include utility bills, cable, mobile phone bills, and insurance premiums.
Accuracy of the Rule of Thumb
While the 28/36 rule of thumb is a good guideline for most borrowers, it has its own weaknesses.
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For example, the debt-to-income ratio does not account for home expenses like basic utilities, groceries, and childcare. This could lead borrowers to underestimate their actual debt-to-income ratio. Don’t forget to also consider home repairs and maintenance, which can average 1% to 2% of your home’s value annually, according to Edelstein.
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Because of these additional expenses, Edelstein said that borrowers should aim for a debt-to-income ratio lower than the maximum of 43% used by most lenders – which is what the 28/36 rule of thumb suggests. By doing so, you may be better positioned to live the lifestyle you desire because less than your monthly debt payments will be tied to a mortgage loan.
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This is why borrowers cannot just assume that being approved means they will actually be able to afford a mortgage payment in the long term.
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Note: The Office of Consumer Financial Protection (CFPB) mentioned that borrowers with high debt-to-income ratios are “more likely to experience difficulty making monthly payments.”
How to Improve Your Debt-to-Income Ratio for a Mortgage Loan
To have an acceptable mortgage loan, look for ways to reduce your debt-to-income ratio before applying for a mortgage.
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One way to lower your debt-to-income ratio is by paying down credit card balances and then keeping those balances below 30% of your credit limit, according to Valdes.
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“It’s also helpful to create a debt repayment plan – such as the snowball debt method, where you tackle the smallest debts first one at a time while maintaining minimum payments on the others,” she said. “Creating a budget and cutting back when necessary can also free up extra money to pay down debt. Gradually paying off smaller debts makes a big difference.”
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Another tip is to time your loan applications wisely. For instance, Edelstein advised against applying for a mortgage while also applying for other types of credit, like a new car loan or a new lease, because new credit can lower your credit score and increase your debt-to-income ratio.
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Here are some other ways to improve your debt-to-income ratio before applying for a mortgage loan:
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Pay off the highest credit card balance, or reduce amounts on all your credit card accounts.
Consider a loan to consolidate credit card debt or other debts at a single interest rate.
Avoid accruing new debt in the time leading up to your mortgage application and before closing on the home.
Look for
Ways you can increase your family’s income, such as negotiating a raise, taking a part-time job, starting a side business, or looking for a higher-paying job with a different employer.
Frequently Asked Questions
What are closing costs,
Source: https://www.thebalancemoney.com/how-much-home-can-you-afford-mortgage-rule-of-thumb-1289846
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