Twenty Eight Thirty Six Rule (28/36 Rule)

The 28/36 Rule is a well-known guideline in personal finance, particularly in the context of mortgage lending. This rule helps individuals and lenders gauge how much debt, particularly in terms of a mortgage, a borrower can reasonably afford. The rule stipulates that a household should spend no more than 28% of its gross monthly income on housing expenses and no more than 36% on total debt service, including housing and other debts such as auto loans, student loans, and credit cards.

Origin and Concept

The 28/36 Rule is not a law but rather a rule of thumb that has developed over time as a practical guideline for both lenders and prospective home buyers. It originated from conventional mortgage underwriting standards used by financial institutions to assess the risk of extending credit to potential borrowers.

The rationale behind the 28/36 Rule is quite straightforward; it aims to prevent borrowers from becoming overburdened with debt, thereby reducing the likelihood of defaults and financial distress. By adhering to this rule, lenders can ensure that borrowers have enough disposable income to cover other essential living expenses and to weather financial emergencies.

Detailed Breakdown

Housing Expense Ratio: 28%

The housing expense ratio, also known as the front-end ratio, limits the percentage of a borrower’s gross monthly income that should go toward housing expenses. These expenses typically include:

• Principal and Interest (P&I): The main components of a mortgage payment.
• Property Taxes: Taxes levied on the property by the local government.
• Homeowners Insurance: Insurance that protects against various risks such as fire, theft, and other hazards.
• Private Mortgage Insurance (PMI): For borrowers who put down less than 20% of the purchase price, this insurance protects the lender in case of default.
• Homeowners Association (HOA) Fees: Fees applicable in certain housing communities.

To calculate the housing expense ratio, use the following formula:

[ \text{Housing Expense Ratio} = \frac{\text{Total Monthly Housing Expenses}}{\text{Gross Monthly Income}} \times 100 ]

The result should be 28% or less according to the 28/36 Rule.

Debt-to-Income Ratio: 36%

The debt-to-income ratio, also known as the back-end ratio, expands on the front-end ratio by including all forms of debt obligations. In addition to the mortgage-related expenses noted above, this ratio considers:

• Auto Loans: Regular payments made toward any financed vehicles.
• Student Loans: Monthly installments paid on education loans.
• Credit Card Payments: Minimum payments required on revolving credit accounts.
• Personal Loans: Installment payments on any personal loans.

The formula for the debt-to-income ratio is as follows:

[ \text{Debt-to-Income Ratio} = \frac{\text{Total Monthly Debt Payments}}{\text{Gross Monthly Income}} \times 100 ]

The 28/36 Rule advises that this ratio should not exceed 36%.

Practical Application

For Lenders

Lenders use the 28/36 Rule as part of their underwriting process to evaluate potential borrowers. This rule helps them determine whether an applicant has the financial capacity to repay the loan. Adherence to these ratios reduces the risk of default, making it a key element in responsible lending practices.

For Borrowers

Prospective homebuyers can use the 28/36 Rule as a self-assessment tool to gauge their financial readiness for homeownership. By ensuring their housing expenses and total debt obligations fall within these limits, individuals can make more informed decisions about how much house they can afford without compromising their overall financial well-being.

Limitations and Criticisms

While the 28/36 Rule is a useful guideline, it is not without its limitations:

• Variability in Living Costs: The rule doesn’t account for the significant variations in living costs in different regions. For instance, housing costs in urban areas may be much higher than in rural areas.
• Individual Financial Situations: The rule is a one-size-fits-all guideline and doesn’t consider individual financial circumstances, such as existing wealth, savings, or future income potential.
• Market Conditions: Fluctuations in interest rates and real estate markets can impact the applicability of the rule. What might be considered affordable under stable market conditions may not hold true during a volatile period.

Conclusion

Despite its limitations, the 28/36 Rule remains a valuable benchmark for both lenders and borrowers. It provides a clear, straightforward framework for assessing the affordability of housing and debt levels, contributing to more responsible financial decision-making. As with any financial guideline, it should be used in conjunction with other tools and considerations to make the most informed and prudent financial decisions.

For more information on mortgage guidelines and financial planning, you can visit Fannie Mae’s official website: Fannie Mae