Embracing the 30% rule can help your budget stay balanced
Most of us dedicate nearly a third of our days to work and use the balance to rest, play, and take care of essentials. So when it comes to buying or renting the homes that will occupy these activities, wouldn’t it make sense to apply a similar ratio?
The 30% rule advises consumers spend no more than 30% of their monthly income on their mortgage or rent payments, leaving wiggle room in case of unexpected expenses, job loss, family planning, and other goals.
It’s a common-sense rule that can spare homeowners (and renters) a lot of unexpected expenses down the road in terms of credit card fees and other borrowing costs. The 30% rule simply improves the ability to squirrel money away for the unexpected. Because let’s face it, the unexpected will happen.
The rule breaks down like this:1
Earmark no more than 30% of your monthly income toward the housing payment.
That’s it, but it takes some calculation. If the household income is $10,000 a month, say, then the total monthly housing payment should not exceed $3,000.
Be sure to count all monthly income sources, including investments, and be realistic about change. Investments do not always appreciate, jobs do not last forever, and pay cuts are possible. Be mindful if a portion of income is tied to a fluctuating source, such as the stock market.
Two notes:
First, this rule is based on calculating 30% of gross income (before taxes and expenses), not net income, which is what a person collects after taxes, retirement savings, investment fees, and the like.
Second, factor escrow expenses and other fees into mortgage payments and rents. A mortgage is comprised of principal (the amount paid to reduce the loan) and interest (the monthly cost of borrowing the money, which decreases with the loan amount). But other expenses will likely drive up that payment:
- Property taxes – collected by local governments and based on the home value. Beware: If the tax is calculated on a previous property assessment, it could increase when the property is reassessed, causing the escrow amount to change.
- Insurance – homeowner’s insurance is typically applied to a mortgage escrow along with property taxes. Renters, too, may be required to buy renters’ insurance as part of the lease.2
These expenses can drive up a monthly payment by hundreds of dollars.
Does the 30% rule always work?
The 30% rule isn’t one-size-fits-all and is best viewed as a guideline. There are certain mortgage and other lending programs that may not fit precisely in this rule. Make sure to check with your lender about program specifics.
Should interest rates influence how much I borrow?
If interest rates are low, buyers can consider earmarking a slightly higher percentage toward the mortgage, because they will be paying less in interest over time.
However, every person has a unique relationship with money, so trust your gut. The less money that is committed to the monthly housing payment, the more homeowners and renters will have for everyday expenses, rainy day funds, and other investments. If one sets some money aside each month in a safe investment fund such as a money market account, for example, it will grow modestly but remain accessible.
This guideline is subject to a few important variables. For example, some housing prices are inflated right now, meaning there is a risk a home purchased for $360,000 today might be worth less in a few years. If waiting is not an option, homebuyers can consider spending less, changing neighborhoods, or researching home alternatives, such as condominiums.
Regardless of the circ*mstances, homebuyers should talk to their banker first about their long-term financial goals.
Not sure whether to rent or buy? Weigh the benefits of each. If you’d like to learn more about mortgages, you can compare our mortgage options and use our interactive calculator to help determine how much house you can afford.
