Since becoming a blogger, I’ve had a number of friends and readers reach out to me about all manner of financial topics. Mostly people want to talk about investing. I’ve actually been surprised by how much people want to talk about investing – it’s a lot! But sometimes they ask other questions, and one that has come up repeatedly relates to a popular rule of thumb for housing costs.
Specifically, the “I heard I should spend xx% of my income on housing” rule of thumb. The percentage varies, but it’s usually quoted as 25%-35%. That’s normally based on your gross (pre-tax) income. I’ve also heard a variation that you should spend 50% of your net (after tax) income.
People ask me about this rule of thumb fairly frequently because they want to check whether their housing spending makes sense. My response is nearly always the same, and comes swiftly:
An emphatic “I hate that rule!”
And I do. I hate that rule. From the beginning of this blog, I’ve talked about how personal finance is personal. There are some financial “rules” that have some statistics behind them and that I trust (although I still think they don’t fit all situations). But I generally hate most rules of thumb related to spending ratios because we don’t all spend (or earn) the same. And I hate this rule of thumb in particular.
The reason I hate it so much, other than being the opposite of personal, is that I’ve seen it lead to friends spending much more on housing costs than they should have. Why? Because they were led to believe that’s what they should be doing. Because they were following the “rule.”
Ugh.
How The Housing Rule of Thumb Is Supposed To Work
In theory, this rule of thumb should help direct you toward housing costs that are reasonable for your income. It’s supposed to keep you from spending too much on housing!
But it can also have the effect of making you spend more than necessary. Or conversely, it can seem like you are spending way, way too much on housing…without accounting for your particular situation. That could unnecessarily lead to feelings of guilt, wastefulness, judging, etc.
Say your household income is $5000/month gross. Let’s assume you pay $800 in taxes each month, leaving you with $4200/month net income.
- 25% of $5000 is $1250
- 35% of $5000 is $1750
- 50% of $4200 is $2100
Okay first of all, can we all agree the range there is enormous? $1250 on the low end and $2100 on the high end!
Second, which one of these “rules” should you follow? Well, that’s not exactly an easy question to answer is it?
Do you live in a high cost of living area where a one-bedroom apartment costs $2100/month? Where I currently live, a three-bedroom house in a good area rents for about $1300/month. When I lived in DC last year, the one-bedroom apartments I lived in were $2359-$2857. My income was not magically twice the size in DC vs where I currently live. That’s not how it works.
Do you live with a partner and/or children? You might need to spend more to have more space. Even if you still make the same income! Strange. Conversely if you move in with a partner who makes roughly the same income, you don’t automatically need housing that costs twice as much.
Do you have other debt that already takes up a big chunk of your net income (hello student loans or medical debt!)? Well then you probably can’t spend another 50% on housing, amiright? You are still going to need things like food.
What About When Your Income Changes?
Now let’s say you change jobs or get a promotion and start earning $5500/month. Your gross income has gone up 10%. Let’s say with your new income you are paying $880 in monthly taxes, leaving you with $4620/month net income. Your new housing budget using these “rules” varies as follows:
- 25% of $5500 is $1375
- 35% of $5500 is $1925
- 50% of $4620 is $2320
Uh, has your housing cost necessarily gone up just because you got a raise? No. Do you have to move just because you got a raise? NO. You can keep living in the same place and just pocket that money. Don’t inflate your lifestyle just because you got a raise.
And I think we all know that your mortgage lender or landlord isn’t going to lower your monthly payment just because you lost your job or took a lower paying one. Let’s say you used one of the higher end “rules” because that’s what you thought you were supposed to do. Well, you may have been able to easily meet a 35%-of-gross housing payment. But if your income goes down 10%, now that same payment is almost 40%. Ouch.
What About Other Housing Expenses?
Good question! Are you thinking about this when you decide which “rule” to follow? For instance, let’s say you bought the house you are living in. Did you include property taxes and insurance (the full PITI) when figuring out if you met the rule? How about HOA fees? Any liens on the house? If you bought a relatively new home, you might still be paying for the cost of installing things like street lights and sewer lines. Yeah, that’s a thing.
Here’s something to consider: if you spend more on a larger house or apartment, you are probably also paying more for taxes, heating/cooling, maintenance, maybe some yard work… all of a sudden you could be spending another 10%+ on housing costs. Did you account for that when you worked out your percentages?
Then there is all the other stuff like new appliances, painting, shingle replacement, etc. This isn’t something people normally associate with the housing rule of thumb…but it is still part of your housing expenses, so it shouldn’t be overlooked.
So why does this rule of thumb for housing even exist?
Well, it actually does have a purpose. Mortgage lenders want to ensure that people will be able to pay their mortgages. Makes sense, right? So they looked at how much people might be able to afford. This is called a qualification ratio, and it has a few elements.
- Up to 28% of the household’s gross monthly income can be used on total housing expenses. For buyers that is probably full PITI plus any other required monthly costs. For renters it often means the monthly rent plus estimated utilities.
- And up to 36% of the gross monthly income can go to the total debt service. That means if you have other debt (credit cards, student loans, etc) the total of your housing and other debt monthly costs shouldn’t exceed 36% of your gross income.
This is known as the 28/36 Rule. It might be a little better than the numbers I showed you up top, I guess. Mortgage lenders can vary the amounts if they so choose, but expect to see something similar to this if you go to buy a home. And renters need to pay attention too. Many landlords require the tenant to have verified income of 3x-4x the monthly rent.
The US government also looked at what a reasonable percentage might be. And the government’s answer was a bit different. They found that consumers experience “housing cost burden” when the housing expenses exceed 30% of the gross income.
I’m not going to bore you with the details but if you like to see data compiled into government reports, this one’s for you!
Basically, these rules of thumb exist to keep you out of trouble by ensuring you aren’t spending too much of your income on housing expenses.
What is the Right Amount To Spend On Housing?
The thing is, the rule of thumb for housing (all of them) is supposed to be an upper limit for how much you can spend on housing. It isn’t supposed to be a goal amount! But too many people treat it that way.
The right amount you should be spending is the amount necessary to secure safe and functional housing that meets your needs. If you have a lot of debt maybe that means you rent a room in someone’s house to keep your housing costs low. If you are way ahead of the retirement savings game like my friend Gwen you might choose to spend a little more on housing.
The point is, it should be based on your needs and wants. Don’t blindly follow a rule of thumb, especially as your financial situation changes. I have a friend who just started to question this last year, after almost two decades of continually increasing his housing expenses as his income went up. His financial situation is great, so this hasn’t hurt him. But it wasn’t done intentionally.
That’s what I’m asking you to do. The next time you hear of a financial rule of thumb, think about whether it really applies to your situation. And if it doesn’t, ignore it. Do what is right for you.
The fact that the 30% “rule of thumb” doesn’t take into consideration anything else is SUPER frustrating. Living somewhere that doesn’t require you to own a car, for example, means that you could be paying 40% toward rent and your budget would still look better overall than someone paying 30% but with a ridiculous commute and car payment. And the student loan/other debt comment is a good one. Other payments (and things like childcare) make each individual situation SO different. And to be honest, if you’re bringing in a super high income, you can “afford” to pay more percentagely on rent than someone on a low income because there are more total dollars left over at the end of the month.
Excellent post, and one I may use in part a Council meeting packet for work next month 🙂
Oh, the commute and car payment part! When I lived in DC I lived in a place where I could walk everywhere I needed (including work) and if I needed to go farther there were multiple, cheap mass transit options. I was able to give up my car which saved $100/month on parking, $64/month on insurance, and about $30/month on gas/maintenance. That extra $194/month let me live in the neighborhood I wanted with no net change to my budget. So yes, the percentage of my housing costs went up, but my transportation costs were miniscule! Looking at the whole picture is so important.
*Standing Ovation*
I don’t understand why people constantly treat a maximum amount as a lower limit, whether that be a speed limit or this housing rule. I’m deliberately trying to lower my percentage spent on housing, which should happen naturally as my income goes up.
I suspect it’s because people only hear the 5-words-or-less mnemonic (spend 30% on housing!) and don’t learn the history or reasoning behind it.
Josh- My guess is that people don’t run the numbers on actual costs. Either because they really have no idea about what’s involved and don’t want to put effort into finding out OR they prefer someone to tell them.
Remember the housing bubble crisis? Banks were telling people they could afford homes that were 10 times more than what their paychecks were People didn’t question it or purchase homes less than what the bank stated. Nice..… And I’ve read recent articles stating that banks were doing it again- sub prime loans.
My pet peeve is the 4% withdrawal rule from retirement funds. I say go lower if you can and higher if you must. Unless the gov’t tells you what to do….
Thank you for putting this into words!
I’ve seen the 50/30/20 budget floating around too and it aggravates me to no end. It’s insulting if you’re a low income earner, and it encourages high income earners to spend more for no reason. There really isn’t a one-size-fits-all when it comes to finances.
Agree..I think people use this rule just to justify unnecessary spending. But one of the easier ways to save is not to change your cost of living as your salary goes up!