Many high-income individuals often question whether or not they should upgrade their home and take on a larger mortgage. After all, if you are making an excellent income (let’s say, $600K per year), why not buy a bigger home? But how much home can you afford? At what point is the cost too much to bear?
It can be challenging to know for sure as each circumstance is unique, but there is a great rule of thumb to help determine how much house one can afford: the 28/36 rule.
The 28/36 rule is a great guideline that financial institutions use to determine how much money you can afford to spend on a home. Both are income-based ratios to help you realistically determine what is affordable.
The 28/36 rule states that your monthly housing expenses, including your mortgage, property taxes, and insurance, should not exceed 28% of your gross monthly income, and your total debt, including your housing expenses, should not exceed 36% of your gross monthly income.
- 28: Your monthly housing expense, or more precisely, your PITI (principal, interest, taxes, and insurance), should be at most 28% of your monthly income.
- 36: Your total DTI (debt-to-income) ratio should not exceed 36%. Note that your total debt will include any debts you may have outside of your mortgage, such as car loans, student loans, and private loans.
The 28/36 Rule in Practice
Let’s say you and your spouse have a combined gross monthly income of $50,000 ($600K per year). According to the 28/36 rule, your housing expenses should not exceed $14,000 per month, and your total debt, including your housing expenses, should not exceed $18,000 per month.
If we were to work backward, we now know that we can safely afford up to a $3.1MM home on a monthly income of $50,000.
Of course, this is just a guideline, and other factors must be considered, such as credit scores and interest rates. In my opinion, however, two more factors, often overlooked, should play a much more significant role when deciding: income stability and time horizon.
If you have a relatively volatile income (you are an entrepreneur, work for a start-up, your industry is cyclical, etc.), then obviously, it would be wise to be quite conservative with these figures. If your income were to take a hit, then being on the hook for a $14,000 monthly mortgage can be devastating.
Likewise, if you have a stable job with a secure income, you can probably afford to push the envelope a bit.
Also, consider your time horizon. If you are 40 years old and plan to work for the next 20-30 years, then undertaking a 30-yr fixed mortgage should be reasonably palatable.
However, if you are 60 years old and five years from retirement, you should be extremely wary of taking on a mortgage, especially if this mortgage is close to the limits of the 28/36 Rule. Nobody wants to spend their retirement writing monthly mortgage checks.
Beware of Mortgage Brokers
Remember that many mortgage brokers and underwriters will likely tell you that you can afford more than the 28/36 Rule suggests. Know that their incentives are to sell the highest mortgage amount possible. At the end of the day, you are the one that has to pay the monthly mortgage, so be prudent in this regard.
Also, be wary of adjustable-rate mortgages. While 7/1 or 10/1 ARM products offer lower rates and monthly mortgage amounts now, they will adjust at some point. We don’t know where interest rates will be at the end of the year, let alone in 7 or 10 years. We are really big fans of 30-year and 15-year fixed mortgages as it is very easy to plan around those fixed payments. If rates do drop in the near term, it is easy to refinance at that point. Just don’t count on it.
Don’t Keep Up With the Joneses
As the saying goes, people tend to buy things they don’t need to impress people they don’t like. Yes, this is true and I, unfortunately, see too much of this.
We have seen individuals with a PITI as high as 50%. This is brutal, especially in high-income tax states such as California and New York. If you make $500K per year, and $250K of that amount goes to your housing expense, that leaves very little for taxes, groceries, and transportation. Not to mention, your savings rate, which should be close to 20%, and travel goals are also probably non-existent. Being house poor is not fun and extremely difficult to get out of. Make sure you don’t make the fatal mistake of turning your dream home into a nightmare.