If you’re like the vast majority of people in this world at some point you will need financial assistance in the form of a loan to help you get through some of life’s challenges such as buying a home, financing a car, financing furniture, financing trips, financing education etc. Typically, you walk into a bank or apply via online bank in today’s day and age to obtain a loan. The bank takes your income, reviews your credit score, and debt load, and assesses your eligibility for the loan; if everything looks good, a loan granted to you for you overcome the financial challenge at hand. For the purposes of this post we are going to focus in on the debt load portion of that evaluation which is often done by evaluating the 28:36 ratio.
The 28:36 ratio was derived out of the need to determine a way to assess a applicant’s borrowing capacity. The front-end number (numerator) of the ratio is the most that applicant should spend on servicing housing debt. The back-end number (denominator) of the ratio is the most the application should spend on housing and all other debt combined (i.e. house payment, student loans, auto loans, credit card payments etc.).
For example, Lets say you make a gross income of $50,000 USD a year, which translates to ($50,000 USD/12 months) $4,166.66 dollars per month (gross income).
The most you should spend on housing costs would be (28% of $4,166.66) or $1,166.66 dollars per month, and the most you would want to spend on servicing debt in total would be 36% of $4,166.66 or roughly $1,500 per month.
While this ratio is an excellent marker for maintaining a lifestyle where your job is steady, and your income is quite predictable from month to month. I recommend keeping your housing costs which are often fixed costs as low as possible (more on this later in a future post on fixed vs. variable costs) to allow you the ability to sustain significant drops in cash flow regardless of how steady and stable your income is because life can be quite unpredictable in the essence that you cannot predict when events will actually happen although you can expect them to happen.
I say this to say that there are common things that every human can expect to experience and endure in life, let’s try our best to prepare ourselves for those things so that we are not so shocked when they occur to us; as there have been many people whom have done this thing called “life” before us, and there will be many thereafter. Death, heartbreak, job loss, failure, etc. are as certain as being born; we all must go through many of the aforementioned experiences just as we all had to be born to be on earth.
My take as I stated earlier, keep your major fixed costs low and your variable costs (costs that you can drop easily in a time of need (i.e. cable bill, gym membership, magazine subscriptions etc.)) manageable and it will allow you to survive the troughs of life and the business cycles.
If you absolutely have to approach the upper limits of the 28:36 ratio, please never exceed 36%. You’ll thank me one day.
P.S. banks often have an upper limit of 42% versus the 36% limit, don’t let yourself be overextended to the higher limit. I am not big on quoting the Bible but I love this quote,
The Rich rule over the poor, and the borrower is servant to thy lender. (Proverbs 22:7)
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