As a first time home buyer, you probably have a lot of questions about the financial side of buying a house. How do mortgage lenders decide what loan amount to assign to you, and how do you decide what loan amount you can handle? The 29/41 rule is a rule of thumb that helps to answer both of these questions. The 29/41 rule holds that no more than 29% of your gross monthly income (your income before taxes) should go toward housing expenses. Also, no more than 41% of your gross monthly income should go toward debt payments.
For California buyers, it’s important to note that the 29/41 rule does not apply to jumbo loans (more on that later).
The 29/41 rule helps you get a more realistic sense of what mortgage you are likely to get approved for and what is financially wise for you. This provides security for the mortgage lender because you’re less likely to default. And it provides security for you so that you don’t get in over your head.
Of course, the 29/41 rule is just a rule of thumb, and everyone’s financial situation is unique. These percentages can vary based on the type of loan you are applying for, your income level, personal financial goals, and the cost of living in your area.
In this article, we’ll delve into the intricacies of the 29/41 rule, how to apply it, and how it affects the home buying process in California.
What is Debt-to-Income Ratio (DTI)?
Before we jump into the 29/41 rule, it’s helpful to understand debt-to-income ratio (DTI). Simply put, DTI compares your total amount of debt payments to your gross monthly income. In other words, it tells mortgage lenders how much you spend compared to how much you earn. DTI is one factor mortgage lenders use to determine the risk associated with lending to you.
Your mortgage lender will calculate your debt-to-income ratio (DTI) to determine how much additional debt you can take on. DTI takes into account common debts like minimum credit card payments, student loan payments, personal and car loan payments, alimony, child support, and any other payment arrangements. It does not take into account utilities, cell phone bills, or other living expenses. Keep reading to figure out how to calculate your DTI.
It’s also important to remember that DTI isn’t the only factor your mortgage lender considers when determining your creditworthiness and the risks associated with lending to you. They’ll also take into account your credit score, down payment, and several other factors.
Understanding the 29/41 Rule
If you’re thinking about buying your first home, one of your first considerations is setting a price range or budget. This helps you get a sense of the kind of house you can afford and whether or not it’s the right time to buy. While debt-to-income ratio (DTI) looks at all your debts, the 29/41 rule specifically emphasizes housing expenses. Thus, the 29/41 rule gives you a framework for determining how much to spend on housing each month.
The 29/41 rule utilizes two formulas. The first formula is related to the first number, 29. This represents your housing expense ratio and is calculated by dividing your mortgage payment (principal, interest, real estate taxes, homeowners insurance, and, if applicable, homeowners association dues and mortgage insurance) by your gross monthly income and multiplying it by 100 to convert it into a percentage.
Principal + Interest + Monthly Real Estate Taxes + Monthly Homeowners
Insurance + Monthly HOA Dues + Mortgage Insurance
Gross Monthly Income
For example, if your monthly housing expenses are $850 and your income is $4,000, then your housing expense ratio is 21%. If your monthly housing expenses are $1,500 and your income is $4,000, then your housing expense ratio is 38%, which is too high. From the lender’s perspective, you’re more likely to miss a payment, and potentially default, with a ratio that high.
The 41 represents your total debt-to-income ratio (DTI) in light of all your debts, including revolving debt (credit cards and other lines of credit) and installment debt (mortgage, car payment, student loans, and personal loans). The formula looks very similar.
Revolving Debt + Installment Debt Payments
Gross Monthly Income
As a general rule of thumb, the 29/41 rule advises you to make sure your mortgage payment is no more than 29% of your gross monthly income while your total monthly debt payments are no more than 41% of your total income. However, debt-to-income ratio (DTI) requirements vary based on the kind of loan you are applying for. The common DTI ratios for major loan programs are as follows:
What You Need to Know If You’re Looking for a Jumbo Loan
Like we mentioned earlier, the 29/41 rule does not apply to jumbo loans. Jumbo loans are used when the loan amount needed exceeds the maximum limit set by Fannie Mae and Freddie Mac for conventional loans. Many California buyers use jumbo loans because the cost of living is higher in California than in most parts of the country. The real estate market is competitive and home prices are higher, so you need to secure a larger loan amount.
A bank or mortgage lender may have stricter rules about the debt-to-income (DTI) ratio because they are giving you more money. With a larger loan comes more responsibility and stricter limits. While conventional loans allow for a DTI ranging from 43 to 50%, jumbo loans typically require a 43% DTI or less.
If you’re a first time home buyer, trying to figure out the landscape of borrowing and budget-setting, the 29/41 rule offers a framework for planning out your housing expenses. Debt-to-income ratio (DTI) and the 29/41 rule help lenders determine the maximum loan amount they’re willing to extend to a borrower while minimizing the risk of default. This benefits both of you by reducing the likelihood of mortgage delinquencies and foreclosures. In California, many buyers require jumbo loans, which have slightly stricter stipulations, but the 29/41 rule is still relevant.
We never want you to feel like you’re in over your head or in this alone. If you have any questions or want more information, send us an email at [email protected].
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