Oct 16, 2020 | 01:11 pm
You've probably come across the rule of thumb which says that you should not spend more than 30% of your gross income on housing. (gross income is your pre-tax and other deduction income. It is not your take-home income). If you own the home, the 30% limit includes principal, interest, taxes, utilities, maintenance, etc. If you’re a renter, the 30% limit includes monthly rent and tenant-paid utilities.
But is that 30% really an important threshold?
There is no science or theory behind the 30%. The number may have come up at least as far back as the 1970s as a representative percentage of income that many households seemed to be spending at that time. Someone documented the figure and it has stuck. This despite the obvious observation that many households don't adhere to it and, in fact, can't adhere to it.
Where you live has a big impact on this rule’s relevance. If you live in New York City or San Francisco you may have to spend more than 40% of income on housing, whereas in a rural setting you may spend less than 20%.
Over the years lenders have also gravitated to 30%, in some cases building it into their loan approval guidelines. This has made the number more relevant when we seek credit approval. But that doesn't change the fact that there is no theoretically sound reasoning for indiscriminately applying it to everyone.
A more correct dollar limit on housing spending comes from the intersection of your household goals/priorities and your budget constraints.
If you prioritize owning a larger home, for example, you want it to be the gathering place for your extended family, you may accept a larger monthly mortgage payment and hence a higher percentage expenditure on housing. Against this you must weigh other priorities, including the need for retirement investing, funding children's education, etc.
The bottom line is that we shouldn't be looking for a "correct" percentage, but rather the dollar number that works within our budget and financial aspirations.