The 2.5 or 3 Times Your Income Rule for Mortgages Is Stupid

Corey —  September 15, 2010

       The personal finance world is filled with stupid rules of thumb that just don’t work when you want the right answer. Sure, they’re easy and simple. But the problem is that they ignore crucial bits of information that are absolutely essential to determining the right choice for you. One of these stupid rules is the idea that you can afford a mortgage that is 2.5 or 3 times your annual income. Here’s why this is just plain dumb.

A. H. Allyn Mansion by cliff1066TM on Flickr

It Ignores Interest Rates

       This one ought be be obvious. This 2.5 or 3 times your income rule of thumb completely ignores the fact that interest rates have a large effect on your payments.

       To keep our example simple, let’s imagine that Bob makes $50,000/year. This rule of thumb says that Bob can afford a $125,000-$150,000 mortgage. We’ll go with $150,000. Today, the rate on a 30 year mortgage is about 4.5%. At this interest rate, Bob would pay $760/month or $9,120/year – about 18% of his gross annual income.

       Rewind to just a couple years ago when rates were 6% and Bob would be paying $899/month or $10,778/year – about 21% of his gross income. Go back to the 2000s when rates were around 8% and Bob would be looking at $1,100/month or $13,200/year – about 26% of his gross income.

       Now, these all sound affordable for Bob but keep in mind that I’m only talking about principal and interest here. I didn’t include taxes and insurance, which could easily put him over the limit in that last example. So one major problem with the 2.5 or 3 times your income rule is that it cannot and does not account for changes in interest rates.

It Ignores the Time Period

       I assumed in the first example that Bob was getting a 30 year mortgage, but this rule of thumb doesn’t really say how long the term should be for your mortgage. I assumed 30 years because it’s the most common and it’s probably what people who spread this stupid rule are thinking. But look at what a difference it makes to go to a shorter time period.

       Using $150,000 as our mortgage amount and 4.5% as the interest rate, we saw that Bob would pay $760/month for a 30 year mortgage. Keep everything the same but change that to a 15 year mortgage with 4% interest (since rates are lower for 15 year mortgages) and Bob will be paying about $1,110/month. So he’s gone from paying about 18% of his gross income to almost 27% simply by choosing a different term for the mortgage.

       This rule of thumb doesn’t help us determine if we can afford a 30 year mortgage or a 15 year mortgage. There’s no distinction at all. That’s strike two!

It Ignores the Rest of Your Situation

       Finally, this stupid rule of thumb completely ignores the rest of your situation on a number of levels. Let’s look at them:

  • Taxes & Insurance – As I showed you before, Bob was getting close to pushing the limits on his income just with his principal and interest payments. What if real estate taxes are high in his area? What if insurance is expensive because he lives in a hurricane zone (or for some other reason)? This rule fails again.
  • Down Payment – What if Bob puts less than 20% down on his mortgage? Well, he’ll have to pay for private mortgage insurance (PMI). Bump up that payment a little bit more now. Oh wait, that doesn’t seem to matter in this rule of thumb.
  • Debt – What if Bob is up to his eyeballs in debt and on the verge of bankruptcy? This 3 times your income rule is absolutely ludicrous in that case, but it doesn’t seem to come with that caveat.

       These are just a few other areas where this rule proves to be absolutely stupid. I’m sure you can think of many more. The point is that simply multiplying your income by 3 to figure out how big of a mortgage you can afford is short-sighted, unwise, and just plain dumb.

The Solution

       There are other rules for figuring out how much of a mortgage you can afford. There’s the 28/36 rule, the 29/41 rule, the 4 times your income rule, the 5 times your income rule, and so on. Now I have to admit that the 28/36 rule is a little better than these “x” times your income rules. But it still ignores a lot about your personal situation.

       By now, the solution ought to be obvious to you. The best way to figure out how much of a mortgage you can afford is to look at your situation and your budget and work backward from there. If you blindly follow the conventional rules, you completely ignore the important factors that can help you make the best choice for you. You also fall into the trap of allowing society, culture, media, or businesses (banks and real estate agents, in this case) determine what your life should look like and how you should spend your money.

       Think for yourself. Work out the math on your own. (It’s not much more than addition, subtraction, and a little multiplication.) Figure out what you need and want. Then determine what fits in to your situation.

What Do You Think?

       What do you think about financial rules of thumb? Why do we like them? What are some rules of thumb you’ve heard that you’d like me to write about? Share your thoughts in the comments below!

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Corey is currently pursuing a Master of Arts degree in religion. While he enjoys learning and writing about Christianity, another one of his new passions is writing about personal finances in order to help others make wise decisions with their money.

6 responses to The 2.5 or 3 Times Your Income Rule for Mortgages Is Stupid

  1. Paul, I agree that the 2.5 – 3 times your income rule is not adequate for really determining what amount of mortgage you can afford, but as a rule of thumb it may be helpful. In other words, assuming you have no major debt, some cash and a fairly normal interest rate environment 2.5 – 3 times your income will put you in the ballpark of what you could buy.
    But yes, using only this method to come up with a number when buying a house would be dumb!

  2. Hey, Trent! Thanks for commenting. I certainly agree that rules of thumb can be helpful if you’re looking for a rough guideline, but too many people ignore the caveats you gave and use it as their only method. To that end, I’d rather proclaim the rule as stupid and point to looking at your specific situation rather than perpetuate the guideline.

    But yes, if your situation falls within the parameters you listed (no major debt, savings in place, and moderate interest rates) then the rule can be helpful for a quick, rough calculation. It should never replace a thorough analysis though.

    Thanks again for sharing your thoughts!

  3. I agree with you, most of these rules are stupid. Even the ones that aren’t often get overused. Many people will apply these rules instead of performing due diligence or even using common sense.

  4. Exactly, Khaleef! We shouldn’t blindly use these rules. We really need to think about our own situation and see what makes sense.

  5. It’s a great rule when you compare it to the rule of thumb mortgage companies and banks applied during the last housing bubble?  Recent bankruptcy?  No money in the bank?  Come on down!  Actually, it’s a terrific rule to apply in the aggregate.  If you look at neighborhoods where people were paying 4x, 5x, or more their average income, those went into foreclosure en masse.

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