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The 30% Rule

How much house can you afford?

Most of us who have bought a house or looked into the process have run across the 30% rule.   You know, the one that says your housing payment should be equal to or less than 30% of your income.

Though we fundamentally do NOT believe in one-size-fits-all financial advice, this is a good starting point when you’re figuring out your price range for purchasing a home.  We do want to add a few additional qualifiers to the 30% rule, however:

  1. “Housing Payment” means principal, interest, taxes AND insurance.  Yep, the whole housing payment, not just the part that you’re paying directly to the loan.  Insurance and taxes can be a significant additional cost, even if the actual mortgage payment fits within 30% of your income. Plus, the mortgage usually stipulates that insurance and taxes have to be paid to maintain ownership.
  2. “Income” means take-home pay, not gross salary.  Anyone who’s held a job knows that Uncle Sam takes his cut of the paycheck first: Social Security, Medicare, and income tax withholding (in most cases).  Plus, you probably have additional deductions for retirement contributions and health insurance benefits.  $4,200/month gross pay quickly turns into $2,700/month after deductions.
  3. The amount the banker pre-approves your mortgage for should NOT influence your price range.  Most banks will lend far more than 30% of income depending on assets and other debt.   For example, Client Jane Doe was approved to spend up to $345,000, but after crunching numbers she could only afford $210,000 if she still wanted to feed her kids three times a day.

All too often, we run into scenarios where lifestyle dictates the cash flow (and subsequent cash flow issues).  The biggest factor influencing lifestyle is your housing payment – at 30% of income it will be the single largest expense every month.

Correcting cash flow issues is never as simple as identifying the one problem area; instead, it’s usually slowly (and painfully) correcting every area until you're able to live within their means again.  When you’re locked into a housing payment you can’t afford, this becomes extremely difficult.

Set yourself up for financial success from the beginning by carefully determining your housing price range and then sticking to it.  First, figure your take home pay.  This should be easy, it’s whatever amount actually hits your bank account each pay day.   Then, run numbers to determine ballpark estimates for insurance premiums, property taxes for the area you’re looking, and interest rates on mortgages.

Multiply take home pay by 30%, then subtract out cost of insurance and property taxes.  What’s left represents the maximum principal and interest payment you can take on.  From there, you can plug your information into simple loan calculators like this one and determine a comfortable price range. (For kicks and grins, you can also play with this calculator to see how much a bank will loan you solely based on gross income, which we do not recommend).