There are numerous “rules” out there regarding how much of your income should cover your mortgage. What makes one rule better than the other? How do you know what is right for you? There are so many factors to consider in this scenario. We will talk about the different options and how they measure up for you.
Look at Your Potential Housing Payment
The first step is to understand a housing payment. It is more than principal and interest. You also have to pay real estate taxes and homeowner’s insurance. If you don’t put down 20% on a conventional loan, you will also pay Private Mortgage Insurance. Even if you don’t use conventional financing, but instead use FHA or USDA loans, you have to pay mortgage insurance. The total of these costs make up your total housing payment. This is the figure you need to use.
When you try to figure out how much you can afford, try to get as many details as possible. Do you know the area you would like to live? If so, you can look up the property taxes for the area. This will give you an idea of the monthly real estate taxes. You can also inquire from your insurance agent what the standard homeowner’s insurance rates are for the area. This helps you start with “real” numbers.
Figure 28 Percent of Your Gross Monthly Income
To figure out the total housing payment you can afford, calculate 28 percent of your gross monthly income. This gives you a conservative amount to work with because you are using pretax dollars. Remember, you still have to pay for your taxes, health insurance, and retirement savings contributions. Taking 28% of the gross amount you bring home leaves enough for other debts and daily living.
Here’s an example:
You make $70,000 per year. This equals $5,833 gross per month. Of that $5,833, you can pay $1,633 towards your total mortgage payment. If the real estate taxes in the area you want to live equal $5,000 per year, this equals $416 per month. Figure in your homeowner’s insurance at $900 per year, so $75 per month and you have $1,142 left for principal, interest, and mortgage insurance. If you did not need mortgage insurance, this means you could afford to borrow around $246,000 for a home. If you add the down payment you can afford to this amount, you have the total amount you can afford to pay for a home.
Don’t Forget Total Debts
Before you jump headfirst into a mortgage, though, you should consider your “other” debts. These are the debts not related to your house. Think of things like your car payment, student loans, and credit cards. You have to pay these bills every month alongside your mortgage. You should try to keep your total payments under 36% of your gross monthly income. If you have excessive debts, it could take away from the amount you can afford on your home. Let’s take a look:
You have minimum credit card payments totaling $150 per month. You also pay a car payment of $500 per month. This means $650 per month in other debts. If you add $650 to the $1,633 (28% mortgage payment from above), you have a total of $2,283. With a $70,000 salary, this equals 39% of your gross income. This is too high. In order to decrease the amount, you have two choices – pay off your credit card debt or take a smaller mortgage.
As you can see, it is a balancing act between your current debts and the new debt you want to obtain. Planning early can help you get the best of both worlds, though. If you were able to pay your credit cards off, it would decrease your monthly debts by $150. Now you only have to worry about your car payment and potential mortgage. If you use the $1,633 payment, you have a total of 36%. This is the ideal maximum amount of debt you should carry at any given time in order to live comfortably without sacrifice.
Lenders Will Approve You for More
Keep in mind, when you secure a preapproval, most lenders will approve you for more. What they are saying, though, is you qualify to receive as much as the amount they state. They do not say you have to take that amount. You should figure out for yourself what you can comfortably afford. The 28/36 rule helps to keep things in line. But, if you are not comfortable with ratios that high, you can even aim lower.
In our above example, with a mortgage payment of $1,633 and a car payment of $650, you would have $3,550 left after you pay your main bills. This leaves you money to pay daily living expenses as well as add to your savings. As a general rule, you should save 1% of the value of your home in an emergency fund per year for repairs/maintenance. You may not spend it all in one year, but at least you have it for an emergency. You also need to save for retirement as well as emergencies. Having $3,500 disposable income can help make these things possible.
Before you decide what percentage of your income you should use for a mortgage payment, look at it in real numbers. The calculations above use your gross income. This is what lenders use to determine what you can afford. However, you know how much money you bring home every month. Work the numbers in to see realistically how much money you have left at the end of each month. Is this enough to live comfortably? Will you be able to make ends meet without struggling? This is important as you don’t want to feel “house poor” or regret your decision. Worse yet, you don’t want to default on your mortgage. This could damage your credit for many years ahead.
Giving careful thought to the percentage of your income that you want to dedicate to your mortgage will help you make the right financial decision for you.