Dave Ramsey has a number of “rules of thumb” for managing your finances. Arguably, his most important is the answer to the question: “How much house can I afford?”
We spend a significant portion of our income on housing, so it’s important to get this question right.
A recent Federal Reserve study found that the cities which suffered the most severe impacts from the 2008 financial crisis were those with the highest average personal debt-to-income-ratios. One common trait shared by residents of these areas was that they bought too much house.
With almost half of U.S. households carrying credit card debt, it’s easy to make the argument that the majority of homebuyers purchase more house than they can afford. Mortgages are one expense that has to get paid — even if that means building up credit card debt.
This post will help you determine not only how much house you can afford, but also how much house you should responsibly buy. Then, we’ll take a look at nine other Dave Ramsey “rules of thumb,” such as how much car you should buy, how much you should save for retirement, and other valuable tips that will help you make better financial decisions.
How Much House Can I Afford (Dave Ramsey’s Guidelines)
Financial rule of thumb: Dave Ramsey’s advice for buying a new home is to limit your monthly payment (including homeowners insurance, homeowners association fees, and property taxes) to 25% or less of your monthly take-home pay on a 15-year fixed-rate loan.
Analysis: This housing rule of thumb is quite different than the recommendations you’ll find elsewhere. Using the affordability calculator on DaveRamsey.com, you can calculate the maximum monthly payment you can afford under these guidelines.
Here’s a look at what Dave Ramsey’s calculator determines a person or family can afford with:
- Home price of $300,000
- Down payment of 10%
- 15-year fixed mortgage
- Interest rate of 3.66%
- Private mortgage insurance of $113 a month
- Property tax at $3,300 a year
- $846 in homeowners insurance cost
The question of home affordability comes down to your monthly income. According to Ramsey’s rule that your housing expenses should never be higher than 25% of your income after taxes, a mortgage payment of $2,410 would mean you’d need take-home pay of $9,640 per month ($2,410 multiplied by four). In this example, that means earning $115,680 per year after taxes.
An alternative calculation method is dividing your monthly take-home pay by four. So, if you take home $5,000 a month after taxes, you can afford a $1,250 monthly payment.
Dave advises using your monthly take-home pay (also known as net income) rather than your gross monthly income. Gross income is the amount you make before taxes and other deductions. Net income is the amount you make after taxes and other expenses are taken out. To get this number, simply look at your recent paychecks.
How Much House Can You Responsibly Afford?
Dave Ramsey’s rules allow you to buy much less house than most mortgage lenders and real estate agents want to sell you — not to mention, much less house than other calculators will say you can afford.
As an example, here’s a look at what Realtor.com’s affordability calculator determines a person can afford based on the income from the previous example, along with estimates of monthly debt and a down payment:
- $9,640 monthly net income
- $500 per month of any other debt, such as student loans, credit cards, or car payments
- $30,000 down payment
Under Dave Ramsey’s guidelines, you’d need a monthly net income of $11,924 ($143,088 annually) in order to afford a monthly mortgage payment of $2,981.
If you look closely, one of the biggest differences between the two examples is the mortgage rate. In the Dave Ramsey example, the interest rate is 3.66%. In the Realtor.com example, the interest rate is 4.459%.
Why the difference? Because a 15-year fixed-rate mortgage typically has a lower interest rate than a 30-year mortgage.
When determining how much house you can afford, interest rates make a world of difference. Being off by even half of a percent can mean the difference between a good and bad decision. A good tip is to head over to Credible, which provides realistic interest rate estimates on a purchase or refinance in as little as five minutes.
Pro Tip: Many first-time home buyers are surprised when they discover how much money goes into closing costs. And more often than not, these closing costs get rolled up into the loan instead of being paid up-front. If that’s your plan, make sure to add at least 2% to your new home’s total cost when calculating your payment.
Who Is Right?
The standard debt-to-income ratio used in the mortgage industry is called the 28/36. What this says is that your total monthly debt payments should not exceed 36% of your pre-tax (a.k.a. gross) income, with a maximum of 28% going towards housing.
Taking a closer look at this ratio, I wrote:
The first thing you need to know about the 28/36 rule is that it’s not a rule used in financial planning. Instead, it’s a rule mortgage lenders use to determine your home loan.
The rule states that you shouldn’t spend more than 28% of your monthly gross income on housing (this includes principal, interest, taxes, and insurance). Then, total loan payments (housing plus all other debt) should not exceed 36% of your gross income.
It’s important to look at this ratio from both a lender’s perspective and a consumer’s perspective. For lenders, the purpose of the 28/36 rule is to determine the largest amount of debt a person can have.
In other words, this is the largest amount of debt banks have found you can take on and still have a reasonable chance of paying back. Loaning you as much money as possible maximizes the bank’s bottom line, not your finances.
You’ll encounter the 28/36 rule during the process of trying to get pre-qualified for a loan. It’s a quick and easy rule of thumb that allows a mortgage lender to provide you with a price range for your home search. (Lenders will also look at your credit score when determining a maximum loan amount.)
Once you progress through the home-buying process and sign a contract on a home, your actual lender will go through a stricter underwriting process. This is where they will take a deep dive into your household income, credit report, debt obligations, bank statements, and more.
It’s during this part of the process that you’ll likely find Dave Ramsey’s 25% rule to be very conservative. Meaning, you’re likely to qualify for a much higher home price using the real estate industry’s guidelines.
At this point, it’s important to take a big-picture view of your finances. Buying as much house as you can afford will take away from other financial goals. That’s why I can’t agree more with Mr. Ramsey on this particular rule of thumb.
If you’ve maxed out your debt, one mishap — such as your car breaking down, a home repair, or a loss of income — can take years to recover from. Those are years in which you’ll be struggling just to get back to where you were.
Other Dave Ramsey Financial Rules of Thumb
Dave Ramsey has a number of other financial rules of thumb. Some are good. Some deserve a closer look.
#1. How much should I spend on a car?
Financial rule of thumb: The total value of all of your vehicles should be no more than half of your annual income.
Analysis: This seems high. The issue for me is that it doesn’t take other debt into consideration. For example, according to this rule a couple earning $100,000 per year combined could have up to $50,000 worth of vehicles. But what if they have student loans, or lots of credit card bills?
There are many high-quality, fuel-efficient used cars available in the $8,000 to $12,000 range.
My rule here is that until you have your non-mortgage debt paid off and are saving at least 25% of your income, stick with a vehicle in the $8k to $12k range.
#2. How should I invest?
Financial rule of thumb: Dave recommends you invest in 25% of your total portfolio in a growth mutual fund, 25% in an aggressive growth mutual fund, 25% in an international fund, and 25% in growth and income.
Analysis: Dave Ramsey is often criticized for his investment advice. In my opinion, that’s for good reason.
Not only is this portfolio very complicated for even intermediate investors, it’s also far from optimized.
Even Time Magazine has said so:
“…if you’ve gotten through the baby steps of conquering debt and [you’re] starting to save, you’d be wise to graduate to better advice on investing.”
I recommend the same.
Read John Bogle’s The Little Book of Common Sense Investing in a night and place yourself in the top 10% of investors.
#3. When should I start investing?
Financial rule of thumb: Once you’ve paid off your non-mortgage debt and have saved up between a three-month and six-month emergency fund
Analysis: This is solid advice for most people… which is, after all, the purpose of a rule of thumb.
However, there are a few situations where this rule may not make sense.
One example is when someone has low-interest debt and a company 401(k) match. Say you have student loans at 5% and a company 401(k) match at 50%. In this scenario, I’d recommend contributing all the way up to your match, and then attacking the student loans with anything you have left.
It’s also worth mentioning that a six-month emergency fund can be difficult to build up, and achieving that goal can take a surprisingly long time. If you feel that a six-month emergency fund helps you sleep better, it’s worth having. However, saving up for an emergency fund and paying off low-interest debt (or investing) aren’t mutually exclusive. One can easily go after both goals at the same time.
#4. How much should I save for retirement?
Financial rule of thumb: Save 15% of your income.
Analysis: This is a good rule of thumb, as 15% is the amount a person needs to save over the course of a lifetime in order to have an equivalent lifestyle during retirement.
But then again, if you’re reading a personal finance blog, you’re probably not typical.
While 15% is a good target to aim for, if you want to retire early (or if you’re starting late), you’re going to need to bump this up. I’d prefer someone to use Personal Capital’s retirement calculator and play around with different saving rates.
Many will be surprised at how much quicker they’ll reach financial independence by bumping up their savings just a few percentage points.
#5. How much life insurance should I buy?
Financial rule of thumb: 10 to 12 times your annual income.
Analysis: Rules of thumb are tricky when it comes to life insurance. For example, say you have a family of three, where each spouse or partner makes $60,000 per year. In this case, each person would buy $600,000 to $720,000 of life insurance.
Next, say you have a family of six in a one-income household, making $60,000 per year. This family would also purchase $600,000 to $720,000 in insurance, even though their needs are much different.
I would prefer someone spend 30 minutes completing a half-dozen online calculators before settling on this rule. (This is one of my favorites, and Dave has one on his site). This will allow you to get a feel for what needs to be planned for.
#6. How big of an emergency fund should I have?
Financial rule of thumb: Big enough to cover three to six months of expenses.
Analysis: This is one rule I personally like to break. I only carry about two months, on average. I like to invest anything over this amount as quickly as possible.
The opportunity cost of having an additional four months of expenses sitting in cash is too high when spread over the course of a lifetime.
My back-of-a-napkin calculation for this is as follows:
Say I have access to credit card debt at a 16% interest rate. If I were to spend 50% of my time in “emergency mode,” I’d be paying on average 8% to carry a lower emergency fund.
As 8% is around what the stock market returns, that figure represents my break-even point. As long as I’m spending less than 50% of the time in emergency mode, I come out ahead. As it turns out, I spend a lot less time than 50% in emergency mode — close to zero percent, in fact.
This works for me, but there are others for whom it might not be such a great strategy. One example is someone who takes a lot of risk in their career.
And of course, there is something to be said for sleeping well, knowing you have six months of expenses saved up.
#7. Should I pay off debt with the highest interest rates or the smallest balance first?
Financial rule of thumb: Pay off the debt with the smallest balance first.
Analysis: Research shows that the majority of people have better success with the debt snowball method, paying off the debt with the smallest balance first. I find that this is especially the case when someone has a lot of small debts they need to pay off, compared to two or three bigger debts.
The most important thing is to pick a method and stick with it.
It’s also important to realize that it’s just the start of your journey of becoming debt free.
#8. How much money do I need to retire?
Financial rule of thumb: Be able to live off of 8% of your nest egg.
Analysis: This goes hand-in-hand with the 12% rule, which in my opinion is dangerous.
Every major study (the most popular being the Trinity Study) has cited maximum withdrawal rates of between 4 to 5%.
In other words, if you have a million-dollar portfolio, you can withdraw $40,000 to $50,000 per year without running out of money. This, of course, is if you have an optimized portfolio.
#9. How much should I spend on an engagement ring?
Financial rule of thumb: One month’s pay
Analysis: This advice works as a rule of thumb — meaning that it’s widely applicable. But if your income is very low, spending the equivalent one month’s pay might have severe consequences on your ability to take care of your everyday expenses. You should never buy something — even something as important as an engagement ring — that puts your financial stability in jeopardy.
If that’s the case for you, take the time to explore lower-cost options that are still meaningful. In Europe, for example, it’s common for even wealthy couples to have simple gold-band or silver-band rings with inscriptions on the inside, as opposed to expensive diamonds. Similarly, they often opt for less expensive gems that have a personal connection — think of birth stones, or the state gem of the place where you and your loved one first met.
If you’re a Dave Ramsey fan, three articles you’ll enjoy on The Ways to Wealth are: