Knowing how much mortgage you can afford is one of the most important steps you can take before buying a home. Getting in over your head can cause buyer’s remorse and worse yet, financial troubles. Before you let that happen to you, learn how much of your monthly income you should spend on your mortgage.
Understanding Gross and Net Income
First, you should know that lenders look at your gross income when qualifying you for a mortgage. This is not your take home pay. In other words, this isn’t the money you see in your bank account. It’s the money you make before taxes and other deductions. If you are being realistic with yourself, you should base how much mortgage you can afford on your net income. This may mean that you take a mortgage that is less than a lender approves you for and that’s okay.
Using the Conventional Guidelines
We prefer to use the conventional guidelines to determine how much mortgage you can afford. While conventional guidelines are a bit more conservative than any other loan program, they help you stay in control of your finances.
According to conventional loan guidelines, your housing payment shouldn’t exceed more than 28% of your gross monthly income. Here’s an example.
Let’s say you make $75,000 per year. Your gross monthly income is $6,250. If you take 28% of that amount, you’d have a mortgage payment equal to $1,750. If your take home pay is 85% of your gross pay, the mortgage payment would actually be 33% of your take home pay. This is why we prefer the conventional loan guidelines as it keeps your mortgage payment as a small portion of your income.
The Total Mortgage Payment
It’s important to understand what goes into the total mortgage payment. When a lender tells you how much mortgage you can afford, the payment will include:
- Real estate taxes
- Homeowner’s insurance
- Mortgage insurance (if applicable)
The $1,750 we discussed above doesn’t mean all principal and interest. You would have to take out 1/12th of the annual real estate taxes, homeowner’s insurance, and mortgage insurance, if necessary. What is left will cover the principal and interest.
Your Total Debt Ratio
Lenders also look at your total debt ratio. This is the total of all debts compared to your gross monthly income. You don’t have to include debts like utilities, school tuition, or insurance payments. It’s only the payments that are included on your credit report. The most common include:
- Credit card minimum payments
- Installment loans
- Car loans
- Student loans
A good rule of thumb is to keep your total debt ratio at 40% of your gross monthly income. If you use conventional or government-backed mortgage programs, your absolute maximum debt ratio allowed will be 43% according to the new mortgage guidelines.
If you don’t have a lot of ‘other debts,’ you may have a little more leeway in your mortgage payment. Lenders might be a little more flexible, allowing your housing ratio to hit 30% or so. This will vary by lender, though.
Only you know how much money you are comfortable spending on your mortgage. Don’t take the allowed amount from a lender at face value. Do your homework and figure out what payment will comfortably fit within your budget. Remember, your mortgage is something you may have for the next 30 years. Think about what you planned for your future. Will you have children? Will you go down to a one-income household? These factors will play a role in how much mortgage you should take on to keep it affordable.