28/36 Rule: Understanding Debt Limits for Credit Applications

A comprehensive guide on the 28/36 rule, which helps individuals and households measure their income against debt to ensure they meet ideal debt limits for credit applications. Learn what it is, how to use it, and see practical examples.

The 28/36 rule is a financial guideline used to help individuals and households determine manageable levels of debt in relation to their income. This article explores what the 28/36 rule is, how to use it, and provides practical examples to understand its application.

What is the 28/36 Rule?

The 28/36 rule is a traditional rule of thumb in personal finance used to determine the amount of debt an individual can afford. It recommends that households should spend no more than 28% of their gross monthly income on housing expenses and no more than 36% on total debt payments, including housing and other debts such as credit cards, car loans, and student loans.

Importance in Financial Planning

Historical Context

How to Use the 28/36 Rule

Calculating the 28/36 rule involves understanding two simple ratios:

1. Housing Expense Ratio (28%)
2. Total Debt-to-Income Ratio (36%)

Housing Expense Ratio (28%)

The Housing Expense Ratio is the percentage of your gross monthly income that should be allocated towards housing expenses. This includes mortgage payments, property taxes, homeowners insurance, and any homeowners association fees.

$$ \text{Housing Expense Ratio} = \left( \frac{\text{Total Monthly Housing Expenses}}{\text{Gross Monthly Income}} \right) \times 100 \leq 28\% $$

Total Debt-to-Income Ratio (36%)

The Total Debt-to-Income Ratio is the percentage of your gross monthly income that should be spent on all debt payments, inclusive of housing expenses and other loans.

$$ \text{Total Debt-to-Income Ratio} = \left( \frac{\text{Total Monthly Debt Payments}}{\text{Gross Monthly Income}} \right) \times 100 \leq 36\% $$

Practical Example

Example Calculation

Consider an individual with a gross monthly income of $5,000. Using the 28/36 rule:

• Maximum Housing Expenses should be $5,000\times0.28 = $1,400
• Maximum Total Debt Payments should be $5,000\times0.36 = $1,800

Evaluating Scenarios

• Scenario 1: Within Limits

  • Monthly mortgage payment: $1,200
  • Car loan payment: $200
  • Total: $1,400
  • This individual aligns with the 28/36 rule.

• Scenario 2: Exceeds Limits

  • Monthly mortgage payment: $1,400
  • Car loan payment: $300
  • Credit card payment: $200
  • Total: $1,900
  • This individual exceeds the 36% debt-to-income limit.

Benefits and Drawbacks

Benefits

Drawbacks

Comparisons to Related Concepts

Debt-to-Income Ratio (DTI)

FAQs

What happens if my debt ratios exceed the 28/36 thresholds?

Can the 28/36 rule be applied flexibly?

Summary

The 28/36 rule provides a straightforward method to gauge debt affordability, promoting a balanced financial outlook crucial for credit applications and sustainable financial health. By calculating and adhering to these ratios, individuals can better manage their finances and enhance their creditworthiness.

References

1. Source 1
2. Source 2
3. Source 3