Rule of 28 is dead
Our guest blogger, Sarah Catherine Gutierrez, CFP®, has her master’s in public policy from the Harvard Kennedy School and is founder and partner of Aptus Financial in Little Rock.
Think smaller on affordability
We officially declare that as of April 2018, the 28 percent home affordability rule is dead. This is the rule that states mortgage, insurance and taxes should not exceed 28 percent of gross pay each month. After running many budgets with retirement plan participants and financial planning clients, we feel strongly that affordability should be measured closer to 14 percent.
The problem with the 28 percent rule is that it seems to date back 80 years ago to an era that didn’t enjoy modern luxuries, like cell phones, cable bills, Netflix, iPhone applications and gym memberships.
While it is difficult to really pin down an origin, we believe that the root of this rule of home affordability reaches back to the United States National Housing Act of 1937. It determined that no more than 30 percent of income should be devoted to housing costs; anything more than that would be a burden. The issue is that there hasn’t been a correction in the assumption to account for expenses that could not have even been dreamed of at the time, or for child care, education and health-care costs that have more than doubled the rate of inflation.
Yet the rule has become ubiquitous and synonymous with an affordability principle, perpetuated from my own Certified Financial Planner curriculum to the pages of search results for money websites and blogs. It is not clear to me that the rule of 28 was ever meant to define what was affordable. In reality, the rule seems to be the breaking point over which borrowers are at risk of default. Should default and affordability really have such a fine line between them?
So how did we arrive at the rule of 14? For us, it is simple addition and subtraction.
Let’s look at the median national income for a household of $60,000. Using the 28 percent rule, a family of four with gross pay of $5,000 per month could allegedly afford housing costs (mortgage, insurance and taxes) of $1,400 per month. But can they? In Little Rock, that means the family could purchase a $260,000 home, assuming 10 percent down. Assuming $3,700 in take-home pay–with nothing taken out for their 401(k)–very frugal spending on utilities and other monthly bills and nothing set aside for emergencies, this would leave just $850 per month for food, fuel, clothing, grooming, entertainment and miscellaneous expenses.
Any borrower somewhat mindful of their budget would calculate the rule of 28 on their gross income and quickly realize it was too high, so they might reduce that assumption to 20 percent and start shopping for a slightly less expensive home of around $180,000. Unfortunately, that is still not in the realm of affordability. A person taking on a loan like that would sign up for a life of living paycheck to paycheck and find it difficult to get ahead.
So what can reality-based buyers afford?
We calculate that the ceiling for home affordability for this family is $125,000 (again, assuming 10 percent down), or a payment of $700 per month. This is 14 percent of their gross pay. While still clipping coupons and cooking most meals at home, this family could save 10 percent for retirement, put a small amount aside for college, take a vacation every couple of years and put aside money into a repair reserve each year.
The 14 percent rule might work for a family that makes $120,000 per year, but not without tremendous effort.
When you add up the typical expenses for a frugal family of four living on $120,000 and saving 10 percent for retirement each year, any housing costs that exceed 14 percent, or a $260,000 home (assuming 10 percent down), will erode the ability to save for retirement, emergencies or home repairs. What is frugal for this family? Driving a $20,000 vehicle for 10 years, taking lunch to work every day, eating out for dinner as a family once a week, a gym membership of $20 per month, and having a clothing budget for the whole family of $150 per month.
This is crazy
I know what you’re thinking. This is crazy. Surely, she must be wrong. But sadly, I am not wrong. This same rule applies to more affluent salaries as well.
With the research of Richard Thaler and Cass Sunstein, we know that these affordability rules play a significant role in anchoring the readers of websites and blogs or receiving advice from financial experts. It is my hope that people reading this will look at the updated rule of 14 as a “nudge” toward a more affordable mortgage, leaving room to live comfortably and save for retirement. We have watched enough people unable to retire or forced to live far below the lifestyle they had lived in their working years. They would do anything to go back and dutifully save for retirement.
I have seen many clients scale down their dream-home plans and even downsize their current home to allow for retirement savings, yet still find very happy lives on the other side. A friend just gave me a wonderful anecdote. She and her husband had found themselves in a beautiful but unaffordable home. Living a life of anxiety, unable to save for retirement or take the vacations they yearned for, they sold their house and bought a very modest house, cutting their mortgage nearly in half.
She joked that from time to time she stares at her fake laminate kitchen backsplash glued to the wall and finds delight in the sight. To her that backsplash is beautiful–it is painted with peace, and stuck on with security and freedom.
This article was originally published in the Arkansas Democrat-Gazette, April 9, 2018.