Determining how much you should spend on a mortgage is a crucial financial decision. While your income is a major factor in how much house you can afford, understanding what percentage of your income should go to your mortgage is key. Is there a “golden rule” for mortgage affordability? While the ideal answer varies for everyone, several guidelines and tips can help you determine the right balance.
Understanding Your Mortgage Payment
A mortgage payment is the amount you pay your lender each month for your home loan. This payment typically includes both the principal (the original loan amount) and the interest. In many cases, it also includes property taxes and homeowner’s insurance, which can significantly impact the total amount you pay. Mortgage payments are usually made monthly, although some lenders offer alternative payment schedules like bi-weekly or semi-monthly options.
Mortgage-to-Income Ratio: Common Rules of Thumb
To figure out how much of your income should be allocated to your mortgage, start by evaluating your income, financial goals, and existing debts. Several rules of thumb can provide a starting point. These examples can help you identify a comfortable and sustainable mortgage payment:
The 28% Rule
The 28% rule suggests that your monthly mortgage payment (including principal, interest, taxes, and insurance, or PITI) should not exceed 28% of your gross monthly income. To calculate this, multiply your monthly gross income by 0.28. For example, if your gross monthly income is $10,000, then $10,000 x 0.28 = $2,800. According to the 28% rule, your monthly mortgage payment should be no more than $2,800.
The 28/36 Rule
The 28/36 rule expands on the 28% rule by also considering your total debt-to-income ratio (DTI). It recommends limiting your mortgage costs to 28% of your gross monthly income and ensuring that your total debt payments, including your mortgage, car loans, student loans, credit card debt, and other obligations, stay below 36% of your gross monthly income. The 28/36 rule offers a more comprehensive view of your financial situation, helping you avoid overextending yourself with debt.
The 35/45 Rule
The 35/45 rule suggests that your total monthly debt, including your mortgage payment, shouldn’t exceed 35% of your pre-tax income or 45% of your after-tax income. To calculate your potential affordable range, multiply your gross income before taxes by 0.35 and your net income after taxes by 0.45. The affordable mortgage amount falls between these two figures. For example, if your monthly income is $10,000 before taxes and $8,000 after taxes, you would calculate $10,000 x 0.35 = $3,500 and $8,000 x 0.45 = $3,600. In this scenario, you could potentially afford between $3,500 and $3,600 per month. The 35/45 rule generally allows for a higher mortgage payment compared to other models.
The 25% Post-Tax Rule
The 25% post-tax rule is a more conservative approach, suggesting that your total monthly debt should be at or below 25% of your post-tax income. To calculate your affordable mortgage payment, multiply your post-tax monthly income by 0.25. For example, if you earn $8,000 after taxes, you may be able to afford up to $2,000 for your monthly mortgage payment. This rule is often favored by those seeking a more financially secure approach to homeownership.
While these mortgage rules of thumb provide a useful starting point, it’s crucial to consider your individual financial circumstances and goals. Consulting a qualified home lending advisor can offer tailored guidance on mortgage options that align with your specific needs.
Image depicting a house icon next to a calculator, symbolizing the process of calculating mortgage affordability.
How Lenders Determine What You Can Afford
Mortgage lenders evaluate your qualifications based on several factors, including your income, debt-to-income (DTI) ratio, and credit score. Let’s examine these factors in more detail:
Gross Income
Gross income is your total earnings before taxes and other deductions. Lenders focus on your gross income, not your net income, when assessing your ability to make monthly mortgage payments. A higher gross income generally indicates a greater capacity to afford a more expensive home.
Debt-to-Income (DTI) Ratio
Your DTI ratio compares your monthly debt payments to your gross monthly income. To calculate your DTI ratio, divide your total monthly debt (including mortgage payments, car loans, student loans, and credit card balances) by your gross monthly income, then multiply by 100. A lower DTI ratio suggests you have more disposable income available for mortgage payments, strengthening your mortgage application.
Credit Score
Your credit score reflects your creditworthiness, based on factors like payment history, credit utilization, and the length of your credit history. A higher credit score signals lower risk to lenders, increasing your chances of mortgage approval and securing favorable terms. Minimum credit score requirements vary by lender, so it’s advisable to consult with your lender for specific details.
Tips for Lowering Your Monthly Mortgage Payments
Securing a lower mortgage payment is a common goal. Here’s some helpful advice on how to achieve it:
Increase Your Credit Score
To improve your credit score, consistently pay your bills on time, reduce existing debt, and avoid opening new credit accounts unless necessary. Be aware that closing unused credit accounts can negatively impact your credit score by increasing your credit utilization ratio.
Extend Your Loan Term
Opting for a longer loan term, such as a 30-year mortgage instead of a 15-year mortgage, can reduce your monthly payments by spreading the loan cost over a longer period. However, keep in mind that this will result in paying more interest over the life of the loan.
Make a Larger Down Payment
Making a down payment of at least 20% can help you avoid private mortgage insurance (PMI), which is typically required for borrowers with smaller down payments. Eliminating PMI can lower your monthly mortgage expenses. Additionally, a larger down payment reduces the amount of money you need to borrow, potentially further reducing your monthly payments.
Image showing hands placing money on a house, symbolizing a down payment.
Request a Home Tax Reassessment
If you already own a home or it’s in escrow, consider filing for a reassessment with your county and requesting a hearing with the State Board of Equalization. Each county performs a tax assessment to determine the value of your property. A reassessment may lower your property taxes, potentially decreasing your monthly mortgage payment. However, a reassessment could also lead to a higher property valuation, increasing your property taxes. Researching beforehand and consulting a qualified tax professional is recommended before seeking a reassessment.
Refinance Your Mortgage
If interest rates have decreased since you obtained your original mortgage, consider a mortgage refinance. While refinancing to a lower rate can lower your monthly payments, carefully evaluate the costs associated with refinancing and determine whether the long-term savings outweigh these expenses. Similar to applying for a new mortgage, improving your credit score before seeking a mortgage refinance is recommended.
In Summary
Ultimately, the ideal percentage of income for your mortgage is unique to your individual financial situation. While several mortgage rules of thumb can provide a helpful starting point, it’s crucial to consider your personal circumstances and goals. Consulting with a home lending advisor or using an online mortgage calculator can provide valuable insights to help you determine the right balance for your mortgage loan.
Mortgage-to-Income Ratio FAQs
1. Do mortgage lenders use gross or net income?
Mortgage lenders typically use your gross income to determine how much you can afford to borrow. Gross income is your total earnings before taxes or deductions. Lenders use this figure to evaluate key financial metrics, such as your debt-to-income ratio, to assess your ability to repay the loan.
2. Does mortgage interest reduce taxable income?
Yes, mortgage interest can potentially be used to reduce taxable income. Homeowners who itemize deductions on their federal tax return may be able to deduct the interest paid on a mortgage. This deduction may apply to mortgages on a primary residence and, in some cases, a second home. However, there are limits and eligibility criteria, so consulting a tax professional for specific guidance is recommended.
3. Does the length of the home loan term impact the mortgage-to-income ratio?
Yes, the length of the home loan term affects the mortgage-to-income ratio. Longer loan terms, like a 30-year mortgage, typically have lower monthly payments, which can result in a lower mortgage-to-income ratio. Conversely, shorter loan terms, like a 15-year mortgage, often have higher monthly payments, leading to a higher mortgage-to-income ratio.
4. What other factors should I consider when determining how much my mortgage should be?
To determine an appropriate amount for your routine mortgage payments, consider factors like your current debts, overarching financial goals, total savings, expected income changes, and current living expenses. A qualified home lending advisor can provide personalized guidance to help you find a mortgage that fits your specific needs.
5. What are the risks of allocating too much income to a mortgage?
Allocating too much income to a mortgage can cause financial strain, limit flexibility, and potentially lead to additional debt. This over-allocation of income toward a mortgage is sometimes referred to as being “house poor.” Higher mortgage payments leave less money for other expenses and emergencies, potentially resulting in further borrowing and increased financial stress.
