The unwritten rule is that your housing costs should not exceed 30 percent (sometimes 28 percent) of your gross income. Historically, expenses any higher than this indicated a cost burden and lack of affordability. Although widely used for decades, the rate may be unrealistic in this day and age.
Gross vs. Net
My first issue with the practice is the use of gross income. Gross income is your pay before federal taxes, state taxes, insurance, and other deductions. By using this instead of your net pay, it gives a false sense of affordability. Your affordability will drop dramatically using your net income in the formula. If you factor in taxes and expenses before estimating, it would be more realistic for a complete budget.
For example, let’s say you make $5,000 per month but only bring home $3,000. If you calculated your maximum housing costs using $5,000, your rent or mortgage would be affordable if it was $1,500 or less. If you used $3,000, $900 would be considered affordable. Currently, the average spent on housing is 37 percent of pretax income. By updating the percentage in the formula, your housing costs would be $1,850 or $1,110, respectively. To maximize your housing costs, you would need to allocate $600 to $740 from some other category of your budget. Maybe that means you get the luxury condo downtown but you give up your car. Perhaps you consider the reverse if you prefer space. You could live in the suburbs for less and use the car to commute to the city.
My second issue with the formula is that it is very capitalistic. It encourages increased spending but lacks the recommendation of analysis and prioritizing. Those applying this formula will find an apartment or buy a house with that number as their goal or maximum. They might not stop to consider that they don’t have to spend that much. They might forget it is a rule of thumb but not a requirement.
My third issue is that the formula is oversimplified. The focus should be on determining the best solution for your needs. You have to see the entire picture to do that. Not only did the formula exclude taxes and the like, but it also fails to consider other high-percentage expenses. Applying 30 percent of your housing may be easy to achieve if you are single and high-earning with no children. What if you have a high student loan payment? Did you take into account childcare?
The estimate isn’t all wrong. It can help you determine if you are overpaying for your housing costs if you significantly exceed 30 percent. The formula can also help you decide to make some changes in your lifestyle. You may realize you are paying too much in taxes because your net income doesn’t cover your estimated costs. You could decide to get a roommate to lower your expenses. Additionally, you could use the formula to get an idea of your maximum mortgage payment inclusive of taxes, insurance, and fees.