So, I was browsing around the library the other day, and I stumbled on a book titled “Your Money Ratios: 8 Simple Tools for Financial Security” by Charles Ferrell. When I glanced over the book, I had to scrape my jaw off the floor. This author had managed to create an entire book out of the same information I learned in one class in my Financial Planning program at Purdue University. No, not one class, as in one semester, one class period. Forty-five minutes. Wow. I have to respect someone who can take a subject that’s hard to write a 5 page paper on and stretch it out to a full-length book.
So, I thought I would take a minute to talk about a financial ratio that is particularly interesting, the rent to income ratio. Here’s what it looks like:
Rent to Income Ratio* = Annual Rent Payment/Annual Gross Income
For example, let’s say I gross the median U.S. household income for 2009: $49,777. Now, let’s say my monthly rent payment is $650 per month. Being numerate, I can multiply the monthly rent by twelve to get the annual rent, which is $7800. Now, let’s apply the formula:
Rent to Income Ratio = $7800/$49,777 = 15.7%
So, what does this mean? Usually, a Rent to Income Ratio below 25% is considered affordable.** So, this suggests our hypothetical household is doing well.
Let’s say that they now want to move up to a larger rental. What can they afford?
$49,777 x 0.25 ≈ $12,444 per year → $1037 per month
So, without applying any real thought or consideration to the matter, we are tempted to conclude that our hypothetical household can afford a $1037 per month payment. But we will not conclude this. Why not? This strategy fails to take the hypothetical household’s other spending into account.
What if our household has significant medical debt? What if they have other financial goals, and the rent will make it harder to reach them? On the other hand, what if they have low levels of discretionary spending, and want to spend more on housing?
This leads me back to the most accurate method I know of for calculating how much rent you can afford: budgeting. You should be able to look at your spending record or checking statements for the past few months to measure your expenses. Then it’s a snap to add it all up to see if you can afford the proposed rent. Oh, it’s not a snap? Try a computer program that tracks your spending and adapts to the transactions you usually enter. then it will be much snappier.
* I was taught that, unless the ratio specifically stated otherwise, all instances of the term “income” meant gross income.
** Yes, New York, San Francisco, and other major metropolitan areas are different. This comes as a surprise to no one. As always, use the good sense your Mother gave you.