Lesson #6 - Living On 80% of Your Net Income

When I qualify someone for a loan, all I’m looking at from a debt ratio standpoint is how much is going out each month in debt payments as a percentage of how much is coming in from a gross monthly income standpoint. Most of the loan programs we do allow that number to go up to 45%. While I’m neither advocating that percentage nor am I an opponent of it, I do have a recommendation that I believe is better. I call it the 80% Solution. It is simply setting up your budget every month so that the total of the money you spend does not exceed your net monthly income by more than 80%. As a simple example, if someone’s income is $60,000 per year and she is in a 25% tax bracket, her net income is basically $3,750 per month ($60,000/12*.75). She would be limited to $3,000 per month ($3,750*.80) to cover ALL expenses – including her house payment, if she were “living” within the 80% rule.

Keep in mind that qualifying ratios will still prevail when determining the amount of monthly payment a borrower can qualify for. So in the example listed above, the maximum debt payment that she could have per month (counting her house), would be $2,250 ($5,000*.45). In other words, her house payment plus all of the other debt obligations that she may have (student loans, car loan, credit cards, etc….) could not exceed that $2,250 figure. What I’m suggesting here is not overriding this number. I think it is just a better mechanism to help a potential borrower stay financially fit. It works out great when both of these numbers are in sync – where a borrowing client meets the qualifying ratios (debt payments, including mortgage, fit within the required ratio allotment), thus allowing him/her to purchase the home, but also when there is a commitment to keep total expenses in check (80% or less than net income), allowing for a lifestyle that is less burdened by monthly obligations in relation to net income.

Why 80% and not some other number? The primary focus behind this specific number is that it allows someone to have an immediate 20% that can be either given away or saved. I believe that both are critical. We are blessed beyond our imaginations (go spend some time in a third world country where the largest percentage of our planet’s people live, and you’ll immediately agree with me). With that blessing comes a great responsibility for us to help. Secondly, as I’ve written about many times, and it is the underlying theme to the “Your Mortgage Matters” book – having adequate savings is crucial to financial health. Living within that 80% framework will go a long way to satisfying both of these objectives. Obviously anything lower than that number is just icing on the cake, providing more flexibility for everything else. If you, and our borrowing clients, can manage to do this, or even better, financial success is sure to follow.