Why it’s smart to follow the 28/36% rule

Maxing out your income to buy your dream house is a one-way ticket to financial trouble. It’s important to make sure you have enough room in your budget for emergencies and unexpected expenses, not to mention retirement savings.

To determine how much house you can afford, most financial advisers agree that people should spend no more than 28 percent of their gross monthly income on housing expenses and no more than 36 percent on total debt -- that includes housing as well as things like student loans, car expenses, and credit card payments. The 28/36 percent rule is the tried-and-true home affordability rule that establishes a baseline for what you can afford to pay every month.

Example: To calculate how much 28 percent of your income is simply multiply 28 by your monthly income. If your monthly income is $6,000, then multiply that by 28. 6,000 x 28 = 168,000. Now, divide that total by 100. 168,000 ÷ 100 = 1,680.

Depending on where you live, your annual income could be more than enough to cover a mortgage or it could fall short. Knowing what you can afford can help you take financially sound next steps. The last thing you want to do is jump into a 30-year home loan that’s too expensive for your budget, even if you can find a lender willing to write the mortgage.

How to get the best interest rate

Snagging a low interest rate can save you tens of thousands of dollars over the life of your loan, so it makes sense to try to get the lowest rate. Here are a few things borrowers can do to make their application attractive and low-rate worthy.

Lenders tend to give the lowest rates to people with the highest credit scores, lowest debt and substantial down payments.

→ Borrowers with FICO scores near or at 800 are in the best position to get the most competitive rate.

Credit Score

It’s a good idea to get your credit in order before you apply for a mortgage. First, check your credit report at one of the big three agencies, Equifax, Experian, and TransUnion. You can get one free copy per agency per year (go to annualcreditreport.com). Carefully review your report and note any incorrect information as well as negative marks.

If you find mistakes on your report, be sure to alert the credit reporting agency immediately. Be aware, you might have to prove that the claims are wrong by providing payment history or other evidence. If it’s a case of identity fraud, then you will have to file a fraud report with your local police department.

Debt-to-income ratio

Your debt-to-income ratio, or DTI, compares your monthly income to your monthly debt. People with high debt relative to their income will have a higher DTI and vice versa. This is an important number because it shows borrowers your bandwidth to assume more debt. The higher your DTI, the harder it will be to get a mortgage, much less a good interest rate. Many lenders won’t consider a borrower with a DTI above 43 percent.

For borrowers, it’s a good idea to pay off as much existing debt as possible to qualify for a mortgage as well as to make room for a mortgage payment. By paying off debt, you’ll be in a better position to manage your monthly costs and open up resources in case you run into emergency expenses.

Monthly expenses are not counted in your DTI, only debt obligations. So you don’t have to include things utilities, gym memberships or health insurance.

Here's how to figure out your DTI:

Add up your total monthly debt and divide it by your gross monthly income, which is how much you brought home before taxes and deductions.

Add up your monthly: $1200 (rent) + $200 (car loan) + $150 (student loan) + $85 (credit card payments) = TOTAL: $1,635. Now, divide your debt ($1,635) by your gross monthly income ($4,000). 1,635 ÷ 4,000 = .40875. By rounding up, your DTI is 41 percent. If you get rid of the $85 monthly credit card payment, for example, your DTI drops to 39 percent.

Down Payment

Bigger down payments can mean better mortgage rates because lenders are risking less money. The loan-to-value ratio, or LTV, takes into account your down payment. The bigger the down payment, the lower the LTV and the less risk the lender will assume.

If you don’t have a large down payment, but are ready to buy you can always refinance into a lower rate later, provided market conditions are favorable. If you decide to go this route, get your finances and credit score in tip-top shape now so you have a better shot at refinancing into a lower rate sooner. The faster you can lock in a lower rate the faster you’ll be able to shave off money from your monthly mortgage payments.

Of course, it’s not always easy or practical to save up a large down payment. There are many first-time homebuyer, government and needs-based down-payment assistance programs available for buyers with no or low down payments. Be sure to check with your local government or talk to your lender about programs you are eligible for. You can also visit our page about some of these programs, which include helpful contact information.