Dave Ramsey has a number of “rules of thumb” for managing your finances. Arguably, his most important rule answers the following question: “How much house can I afford?”
We spend a significant portion of our income on housing, so it’s important to answer this question correctly.
A recent Federal Reserve study found that the cities that suffered the most severe impacts from the 2008 financial crisis were those with the highest average personal debt-to-income ratios. And one common trait shared by residents of those 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 home buyers purchased more house than they can afford. After all, mortgages are one expense that has to get paid — even if that means building up credit card debt.
How Much House Can You Afford?
Dave Ramsey’s advice for buying a new home is to limit your monthly mortgage 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.
This housing rule of thumb is quite different from the recommendations you’ll find elsewhere. Using the affordability calculator on DaveRamsey.com, you can calculate the maximum monthly house payment you can afford under these guidelines, which is all based on the simple question, “What is your monthly take-home pay?”
According to Ramsey, your monthly housing expenses should never be higher than 25% of your monthly after-tax income. So, if you take home $5,000 a month after taxes, you can afford a $1,250 total monthly housing payment.
Therefore, you hardly need to use the calculator to follow this rule. To find out your monthly maximum mortgage payment, just take your monthly-after-tax income and divide it by four.
|Monthly Net Income||Max Mortgage Payment|
Ramsey advises using your monthly take-home pay (also known as net income or after-tax monthly income) rather than your gross monthly income.
Gross income is the amount you make before taxes and other deductions, while 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 rule allows 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.
Ramsey’s affordability calculator also gives you an estimate of how much house you can afford based on your monthly take-home pay:
In contrast, here’s what Realtor.com’s affordability calculator says you could afford based on the numbers shown in the example above.
For the sake of this exercise, we’ll base our comparison on the 20% down-payment calculation, as follows:
- $5,000 monthly income ($60,000 annually).
- $42,248 down payment, which represents a 20% down payment in Ramsey’s example.
- $0 Monthly debt. (Ramsey’s Baby Steps framework says you should be out of debt and have a fully-funded emergency fund before buying a home.)
Keep in mind, Realtor.com is showing you what you can afford on a 30-year fixed-rate mortgage. Ramsey, on the other hand, suggests a 15-year fixed-rate mortgage. Yet Realtor.com shows a mortgage payment that’s $579 higher than what Ramsey suggests.
Why such a difference? To understand that, it’s important to understand the guidelines used by mortgage providers.
Dave Ramsey Housing Guidelines vs. 28/36 Mortgage Rule
The standard debt-to-income ratio used in the mortgage industry is called the 28/36 rule. What this says is that your total monthly debt payments should not exceed 36% of your pre-tax income, with a maximum of 28% going towards housing.
Taking a closer look at this ratio, I recently 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 the 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.— The Personal Finance Ratios You Need to Know
The big takeaway here is that Ramsey’s guidelines are optimized to help you build wealth. With a lower mortgage payment, the idea is you’ll be able to avoid credit card debt and invest more over time. Not only will you have a lower monthly payment but also 15 fewer years of making payments.
The mortgage industry’s guidelines, on the other hand, are optimized to maximize their profits.
Dave Ramsey Mortgage Rule vs. 50/30/20 Budget
One of my favorite budgeting techniques is the 50/30/20 budget, which states that you should spend 50% of your income on needs, 30% on wants, and 20% on savings.
Where I find this budget strategy most useful is in helping people make big financial decisions by creating a hypothetical budget for their future.
Housing costs, which include home maintenance, fall within the 50% of your budget allocated to “needs.” However, so do other necessary monthly expenses, such as food, transportation and insurance.
If it turns out that your hypothetical budget has 65% of your income going towards needs, that leaves only 35% total for wants and savings. In other words, your opportunity cost for buying a larger home means sacrificing wants (e.g., travel and entertainment) or savings (e.g., you may have to delay retirement).
It’s not that you’ll necessarily be house poor; however, you’ll be constantly sacrificing other financial goals to make the mortgage payment every month.
How Much Down Payment Do You Need to Save?
What does Ramsey have to say regarding down payments?
To summarize his recommendations:
- The goal should be to save 20% of your home’s purchase price to avoid private mortgage insurance (PMI).
- If you haven’t saved 20% after two years of intense saving, it’s OK to go lower than 20% but not less than 10%. At less than 10%, you’ll be paying so much in fees, mainly PMI, that it’s not worth it.
Private mortgage insurance 101: Private mortgage insurance (PMI) is a type of insurance that borrowers are required to purchase if they have a conventional loan and made a down payment of less than 20%. This insurance protects lenders in the event that borrowers default on their mortgage. Homeowners with PMI are also typically required to pay an annual premium, which is added to their monthly mortgage payment. You eliminate the extra monthly cost associated with PMI once you have 20% equity in your home.
Keep in mind, these down payment figures are for a 15-year fixed-rate mortgage, which is the only mortgage term Ramsey recommends. In other words, the same 10% down payment rule doesn’t apply to someone applying for a 30-year fixed-rate mortgage, according to Ramsey.
Ramsey also doesn’t recommend FHA loans because of the impact of mortgage insurance.
Dave Ramsey Mortgage Rule vs. My Own Thoughts
For most people, their home is the largest purchase they’ll ever make. Just as important, since most homeowners borrow money, there’s also leverage involved.
It’s for these two reasons that I agree with Ramsey’s premise that many people buy too much house. Doing so often forces them to sacrifice their other, and often more important, financial goals.
Yet, I can point to some scenarios where I’d break Ramsey’s strict adherence to a 20% down-payment (or no less than 10% after two years of intense savings) and a 15-year fixed-rate mortgage.
When it comes to a 30-year fixed rate loan, with interest rates so low, this is a legitimate option. However, I really advise a 20% down payment in this case or the ability to pay off PMI within a year or two.
Yes, it’s old-school. However, similar to paying off debt, when you save for a house, it’s your chance to really build your financial muscle. It takes time and requires discipline, but if you can save for a down payment of 20%, you’ve gone out and proved you can responsibly handle the financial ups and downs of owning a home.
If you’re a Dave Ramsey fan, three articles you’ll enjoy on The Ways to Wealth are: