The Truth About the Credit Crunch - Revisiting the 28/36 Debt-to-Income Ratio Rule

Do you know where the 28/36 rule comes from? If you have ever applied for a mortgage, you may well have wondered about where that 28/36 debt-to-income ratio rule came from that the mortgage broker talked to you about. And whether it makes sense... Read on to discover some surprising facts.

When you apply for a mortgage, the banks will usually calculate your debt-to-income ratio.  The idea is that your total monthly debt repayments shouldn't be above a certain threshold relative to your income.

And there are two numbers. The first one concerns your housing expenses. Your monthly payments towards principal, interest, taxes and insurance for your housing should be no more than 28% of your gross income.

The second number deals with your total monthly debt payments, including credit card payments, car payments, other loans, and housing payments. Those should be less than 36% of your gross income.

But where did these rules come from? After some research, here's what I came up with:

After your mortgage has been created by a mortgage company, it is usually sold to an organization like Fannie Mae or Freddie Mac. These organizations are Government Sponsored Entities, or GSEs, and as such have GSE Standards to abide by regarding what mortgages they can purchase. These aren't rules made by Fannie or Freddie, but some government bureaucrats who did the calculations and figured out these income ratios.

Now here is what kind of thinking went into these rules: They're all about the mitigation (lessening) of risk. For whom?  For whoever owns the loans!

Most loans don't stay with the bank that made the loan. Most of them are sold. And the investors that buy them want to make money while minimizing their risk.

Interestingly, there are two contradictory types of risk that can affect the profitability of any loan:

First, there is the risk of default. That means that the home owner can no longer meet the debt payments and defaults on the mortgage. If that happens, the investor stands to lose money.

Second, however, is a very different risk -- the risk of pre-payment. This means that the home owner prepays the mortgage, which saves him or her a lot of interest, interest that the investor won't get.

So the 28/36 rule has been arrived at in an effort to find an equilibrium between the amount a homeowner can take on as debt without defaulting on the loan, but also to ensure that they have enough debt so they won't be likely to pay the loan off early.

And 36% of gross income is a substantial amount of money. In the 1950s, they would think you were on the brink of disaster if you had total debt in excess of 25% of your total monthly income. In fact, during the fifties, much higher down payments were the norm (up to 50% or more).

Now, the trend is to borrow as much as we can while still being able to make the payments. This is a system that's designed to keep us in debt forever. We've all seen where that can get us.  But we don't have to keep playing that game.

I believe it's time to rewrite the rules -- to free up money so we can create wealth for ourselves. Just because the bank allows us 36% of indebtedness doesn't mean we have to actually BE that much in debt. We can lower that ratio -- the lower the better -- and whatever we don't have to pay to creditors, we can pay to ourselves and invest for our own financial futures.

How best to do that? Get a plan. Increase your income and pay off the debt. Keep track of your progress, and give yourself a big pat on the back as your debt-to-income ratio goes down month after month -- and your investments go up.