How Much of Your Income Goes to Housing

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This is part three of an ongoing series about housing costs. Check out part one and two on our blog.

Are you searching for a place to rent? Shopping for a new apartment (or first apartment) can be stressful – finding a good location with public transportation, hoping for the amenities that you want, and striking a deal on a place before anyone else does. This stress can be exacerbated in competitive real estate markets like New York that can cause you to jump on something that may not actually fit your financial goals. So how do you go about starting the apartment search? First, understand what you can afford.

What is the 30% Rule?

Ever heard of the 30% rule? It's the idea that you should budget a minimum of 30% of your income for housing costs, and it's practically personal finance gospel.

Affordability calculators often use it as a default assumption to determine how much house you can afford; mortgage lenders have adopted it as a qualification ratio when approving you for a loan, and private landlords often require tenants' annual salaries to be at least three times the monthly rent.

But who exactly is following this rule? And does it make good financial sense to do so?

Do Earnest Clients Spend Above the 30% Rule?

To address the first question, Earnest took a look at our dataset of more than 15,000 student loan applicants.¹ We found that at salary levels below $30,000, spending above 30% of gross income on housing is the norm. (This is supported by a recent Harvard report, which found that 45% of households who make $30,000-$45,000 have rent costs above 30%.)

At incomes above $30,000, however, Earnest applicants increasingly have lower monthly expenses than the benchmark — down to around 10% of their gross incomes for the wealthiest renters. This reflects the economic idea that a person's marginal propensity to consume generally decreases with increasing income. In other words, if your income doubles, you'll likely start spending more, but not a full two times more.

Among Earnest's loan applicants, people making around $30,000 happen to be following the 30% rule, but generally, most people are paying much more or much less.

Should the '30 Percent Rule' Even Be a Rule?

So, should the 30 percent rule even be a general rule at all? To answer that question, we turned to experts David Bieri, an associate professor of Urban Affairs at Virginia Tech, and Carrie Friedberg, a San Francisco based certified money coach.

The short answer: No. Here are four reasons why.

1. The 30% Rule Is Outdated

The 30% rule has roots in 1969 public housing regulations, which capped public housing rent at 25% of a tenant's annual income (it inched up to 30% in the early 1980s). Rather than looking at what consumers should be spending on housing, however, the government selected the percentages because that's what consumers were spending.

"This is what one did on average in the past, and as such [the benchmarks] become absorbed into public policy," says Bieri, who has written several papers on the subject.

Bieri sees two problems with making 30% the de facto personal finance rule for renters: First, averages, by definition, do not take into account the huge variations of what individuals do. Second, the balance sheet and financial obligations of today's consumers are vastly different than those of the 1960s on whom this rule is based. Americans back then, for example, didn't contribute to 401(k) plans or have high student debt.

2. The 30% Rule Ignores Your Full Financial Picture

Let's do some back-of-the-napkin calculations. Say you're making $30,000 per year and have no household debt. According to the 30% rule, you'd be able to spend $750 per month on rent, which would leave roughly $1,300 a month for savings and expenses (or $325/week, or $46/day), after taxes.

"Quick calculations: $30,000 / 12 months = $2,500 x .3 (30% rule) = $750 per month on rent and $1,300 a month left over for other payments and savings."

Sounds great — until you start subtracting student loan payments (income-based repayment plans typically cap them at 8-10%) and retirement savings (ideally 10-15%). All of this could subtract another 15-20%, without accounting for food, entertainment, transportation, child care, additional debt or other savings.

3. The 30% Rule Doesn't Make Sense for High Earners Either

And if you're making $300,000 per year? The 30% rule would prescribe spending $7,500 a month on rent.

"Quick calculations: $300,000 / 12 months = $25,000 x .3 (30% rule) = $7,500 per month on rent and $13,000 a month left over for other payments and savings."

Friedberg says even high earners may have debt, child support, alimony, elder care or other substantial expenses — like saving for retirement. And in the long run, paying 30% on rent may be an irresponsible practice.

"High earning individuals with a passion for their job and a commitment to their location might consider making a better investment in [buying] a house, condo or an apartment," says Friedberg.

4. The 30% Rule Doesn't Take Your Personal Situation Into Account

Last but not least, as Bieri pointed out, all renters' needs are not alike. Young, city-dwelling professionals with an active social life might not need or want more than a conveniently located small, two or three room apartment they can share with roommates, for example. Contrast their budget to that of a young family (who might have the same income as the professional roommates) looking for space for children and willing to pay a premium to be near good schools.

Creating a Budget For Your Personal Financial Situation

So what's a better rule of thumb? Instead of blindly following the 30% rule, create a realistic budget specific to your life. "When you have a thorough picture of your financial life, you can run various scenarios to determine how much you can afford to pay," says Friedberg. "There is no magic, one-size-fits-all answer."

Creating a budget may sound daunting but it can be quite simple. Here are 3 tips to follow:

Tip 1 – Begin tracking all of your current expenses with an online tool.

Use sites like Mint.com for free or MoneyMinderOnline for a small monthly or yearly fee. After tracking your expenses for a bit, see how much is left over for housing and notice areas where you can cut back and save more.

Tip 2 – Save an Emergency Fund

For earners who are able to save, Bieri recommends using a different benchmark altogether: the three-month emergency fund. Look at your cash flow and liquidity, he suggests, to calculate whether you have enough of an emergency account to cover three to six months' worth of rent and debt obligations if you were to lose your income. The math may be trickier, but you'll have a much clearer sense of how much rent you can comfortably afford.

Tip 3 – Try The 50/30/20 Budget

If you still like some guidelines like the 30% rule provides, try the 50/30/20 monthly budget. Using this rule, calculate what your after-tax income is. From there, use 50% of your take-home pay for housing, utilities, groceries, transportation and other non-essentials that typically cost the same month to month. Use 30% of your take-home pay on non-essentials, or "wants", like clothing, dining out, and entertainment. Lastly, use 20% of your monthly income to save and make extra payments on your debt.

^{1.Data reflects applicants aged 18-34 who applied for an Earnest loan with rents of $100 or more and incomes of $1,000 or more.}

Conquer your student debt. Refinance now.

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Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.

How Much of Your Income Goes to Housing

Source: https://www.earnest.com/blog/rent-and-the-30-percent-rule/

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