Understanding the 28/36 Rule
The 28/36 rule is a fundamental guideline for managing your finances by ensuring that the amount of debt you take on is sustainable. According to this rule, a household should not exceed spending 28% of its gross monthly income on total housing costs and should limit debt payments, including housing expenses, car loans, and credit cards, to no more than 36% of gross monthly income.
Lenders frequently use this rule when evaluating credit applications to assess the risk of lending money.
Key Principles of the 28/36 Rule
- The 28/36 rule provides a framework for determining prudent levels of debt based on income, other obligations, and personal lifestyle.
- Consumers can use the 28/36 rule to devise effective monthly budgets.
- Adhering to the guidelines of the 28/36 rule can boost the likelihood of credit approval, even if you’re not currently applying for credit.
- Lenders may adjust the ratios on a case-by-case basis, often factoring in credit scores to establish their parameters.
Financial Clarity with the 28/36 Rule
Lenders consider multiple criteria when deciding to approve credit applications, and one key element is your credit score, which needs to meet threshold requirements. Nevertheless, your income and debt-to-income (DTI) ratio also play crucial roles in this decision-making process.
The 28/36 rule acts as an indicator of your financial health, showing how much debt you can manage based on income and existing obligations. Debts that surpass these ratios are typically harder to manage and may increase the risk of default.
Lenders apply this guideline to frame their underwriting standards. Some lenders might be more flexible for borrowers with superior credit scores, allowing slightly higher debt-to-income ratios.
Example of Applying the 28/36 Rule
Suppose a family has a monthly gross income of $5,000. Following the 28/36 rule, they should allocate up to $1,400, or 28%, toward housing expenses. If they keep their housing costs to $1,000 (20%), they’re left with $800 for repaying other debts.
What Comprises Your Gross Income?
Gross income is the total of your earnings from all sources, ignoring deductions such as taxes, retirement contributions, or employee benefits. What’s left after these deductions is known as net income, which reflects the actual amount you receive in paychecks. The 28/36 rule is based on this gross monthly income figure.
Components of Housing Expenses
When calculating the housing component of the 28/36 rule, lenders consider the monthly mortgage payment, property taxes, homeowners’ insurance premiums, and any homeowners’ association dues. In some cases, utilities may be included, although these are usually counted under total debt expenses.
How to Compute Your Debt-to-Income Ratio
Your debt-to-income ratio is found by dividing all monthly debt payments by gross monthly income. This calculation encompasses not only the mortgage, but also car loans, credit card payments, and potentially personal and student loans.
The Path Forward
Every lender determines unique criteria for housing debt and overall debts as part of the underwriting process, ultimately deciding your loan approval eligibility. To meet the 28/36 rule requirement, your rent or mortgage payments should not exceed 28% of gross income, and total debts shouldn’t surpass 36% of your income.
Having an exceptional credit score can offer some flexibility in these calculations; therefore, focusing on improving your credit score can be beneficial if your terms are at the margin of acceptance.
Related Terms: gross monthly income, credit score, default, underwriting, debt service.
References
- Social Security Administration. “Gross and Net Income: What’s the Difference?”
- Consumer Financial Protection Bureau. “What Is a Debt-to-Income Ratio?”
- Federal Deposit Insurance Corporation. “Loans and Mortgages”.
