Definition
The 28/36 Rule is a guideline used by lenders to assess a potential borrower’s creditworthiness. According to this rule, a household should spend a maximum of 28% of its gross monthly income on total housing expenses and no more than 36% on total debt service, including housing and other debt such as car loans and credit cards. This helps lenders determine the risk associated with granting a mortgage or loan.
Phonetic
The phonetics of the keyword “Twenty Eight Thirty Six Rule” (28/36 Rule) is:/ˈtwɛntiː ˈeɪt ˈθɝːdiː sɪks ruːl/
Key Takeaways
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- The 28/36 Rule is a guideline used in the financial sector, mainly when assessing credit worthiness and mortgage lending. It helps lenders to determine how much loan an individual can manage by establishing limits on debt levels.
- According to the rule, a household should spend no more than 28% of its gross monthly income on total housing expenses (including property taxes and insurance) and not more than 36% on total debt service (including housing and other debts such as car loans or student loans).
- While this rule is a useful starting point for limiting debt levels, it doesn’t take into account factors like the total amount of savings, the cost of living in a certain area or other personal or financial considerations. Therefore, it may not be appropriate for everyone and should be used with caution depending on individual circumstances.
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Importance
The Twenty Eight Thirty Six Rule, or 28/36 Rule, is crucial in finance and business as a benchmark used by lenders to assess a potential borrower’s creditworthiness. This rule stipulates that a household should spend a maximum of 28% of its gross monthly income on total housing expenses, and no more than 36% on total debt service, including housing and other debts such as automobile loans and credit cards. It’s instrumental in ensuring sustainability and financial stability, as following this rule generally means a person or household is living within their financial means and is less likely to default on their loans, reducing risk for lenders.
Explanation
The 28/36 rule is primarily used as a benchmark in the world of finance, particularly in the area of personal finance, to determine the loan amount an individual can afford. Essentially, it is an income to debt ratio guideline that lenders utilize when approving loans for borrowers. This rule is particularly useful to gauge an individual’s financial stability and their ability to pay back a loan, thereby helping lenders mitigate potential lending risks, while giving individuals a clearer understanding of their borrowing limits.The rule indicates that a household should not spend more than 28% of its gross monthly income on total housing costs, and no more than 36% on total debt service, including housing and other debt such as car loans and credit card payments. By adhering to this guideline, an individual is likely to maintain a good balance between their income and expenditure, ensuring that they aren’t overburdened by debt. Lenders, on the other hand, can feel more secure in providing loans, knowing that the borrower possesses a reasonable capability of repayment.
Examples
1. Buying a House: Jane has a monthly income of $5,000. According to the 28/36 rule, she should allocate no more than $1,400 (28% of $5,000) towards housing expenses such as her mortgage, property taxes, and insurance. Furthermore, her total monthly debt payments, including car loans, student debt, and credit card payments, in addition to her mortgage, should not exceed $1,800 (36% of $5,000).2. Car Financing: John earns $60,000 a year, or $5,000 per month. He wants to buy a new car and has monthly student loan payments of $200. The 28/36 rule indicates that his total monthly debt obligations including car loan, student loan, and any other debts should not exceed $1,800 (36%). Therefore, his car loan monthly payments should not exceed $1,600.3. Loans and Credit Assessment: A lending institution uses the 28/36 rule to assess loan approval for an individual who desires to open a new business. The individual makes $100,000 a year, so only $2,333 (28% of approximately $8,333 monthly) would be thought suitable for housing expenses, and no more than $3,000 (36% of about $8,333 monthly) should go towards total debt service, including housing, credit card bills, student loans, and the proposed business loan. Based on this rule, the bank can decide whether or not to grant the business loan.
Frequently Asked Questions(FAQ)
What is the Twenty-Eight Thirty-Six Rule (28/36 Rule)?
The 28/36 rule is a guideline used in the field of finance to measure a person’s ability to manage monthly payment and repay debts. The rule suggests that a household should spend a maximum of 28% of its gross income on total housing costs and no more than 36% on total debt service, including housing and other debt such as car loans and credit cards.
How is the 28/36 Rule calculated?
It’s calculated based on gross income before tax. For the 28% rule, it involves multiplying your gross monthly income by 0.28. For the 36% rule, you multiply your gross monthly income by 0.36.
Why is the 28/36 Rule important?
The 28/36 Rule is considered an important rule of thumb to help individuals avoid over-indebtedness. It especially serves as a benchmark that lenders use to determine whether a borrower can afford a mortgage.
Are there exceptions to the 28/36 Rule?
Yes, there can be exceptions. These ratios are guidelines and lenders may choose to lend to consumers who exceed these ratios, considering other factors like high credit scores, substantial assets or a large down payment.
What do the percentages in the 28/36 Rule represent?
The percentages in the 28/36 Rule represent parts of an individual’s gross income. 28% is the suggested maximum portion of income that should be spent on housing costs, while 36% is the suggested maximum portion of income that should be spent on total debt service.
What does the 28/36 Rule mean for potential homeowners?
The rule helps potential homeowners understand how much they can afford to borrow when buying a home, ensuring they don’t take on a mortgage that could cause financial difficulty in the future.
Can the 28/36 Rule be used outside of mortgage approvals?
Although it’s generally used for mortgage evaluations, you can also use the 28/36 rule to budget your own expenses and manage your personal finances in a more balanced and healthier way.
Related Finance Terms
- Debt-To-Income Ratio
- Front-End Ratio
- Back-End Ratio
- Mortgage Underwriting
- Consumer Credit
Sources for More Information
