Use the 25% Rule to Decide How Much Home You Can Afford

When it comes to buying a home, one of the biggest challenges is figuring out exactly how much house you can reasonably afford. After all, you don't want to end up "house poor," paying so much for your mortgage that you have little left over for other expenses and savings. That's where the "25% rule of thumb" can be a helpful guideline.

What is the 25% rule of thumb?

The 25% "rule" states that your total monthly housing costs (including your mortgage payment, property taxes, homeowner's insurance, and any homeowners association fees) should not exceed 25% of your net monthly income. In other words, if your monthly take-home pay (after tax) is $6,000, your total monthly housing costs should be no more than $1,500.

Why does the 25% rule make sense?

This rule can be useful for a few key reasons:

1. It helps ensure your housing costs are reasonable in relation to your overall income. Keeping housing at or below 25% of your income leaves room in your budget for other important expenses like food, transportation, healthcare, and saving for the future.

2. It provides a simple, straightforward way to estimate your maximum home purchase price. Once you know your net monthly income, you can quickly calculate the maximum monthly payment you should target, and then use that to determine the home price you can afford.

3. It aligns with common mortgage lending guidelines. Most lenders use around 36% debt-to-income ratio as a benchmark for approving mortgage applications, so the 25% rule can help ensure you stay within those parameters.

When is it OK to break this rule?

Of course, the 25% rule is just a general guideline, and there may be times when it makes sense to deviate from it. Here are a few situations where it might be OK to break this "rule":

• If you have a reliable secondary income source that isn't factored into the 25% calculation. This could allow you to comfortably spend a bit more on housing.

• If you have minimal other debt, such as car loans or student loans. The lower your overall debt burden, the more housing costs you may be able to handle.

• If you live in an area with a particularly high cost of living. In these cases, sticking to the 25% rule may make it very difficult to find an acceptable home, so you might need to spend a bit more.

The key is to look at your entire financial picture-income, other debts, expenses, savings goals-and determine what housing costs you can truly afford, even if that means exceeding the 25% guideline in some cases. As with most personal finance advice, the 25% rule is a helpful starting point, but your unique circumstances should ultimately guide your home-buying decisions.