Lenders look at your debt-to-income ratio when deciding if you can afford a mortgage. But what percentage of income do they think is ‘acceptable?’ Should you take their word for it or is there another percentage you should worry about?
Every loan program is different when it comes to determining what you can afford. Conventional Fannie Mae loans, for example, allow a 28% front-end ratio. That means 28% of your gross monthly income can cover your mortgage payment. FHA loans, on the other hand allow a 31% front-end ratio. VA loans don’t even have a ratio; they rely on your monthly disposable income.
So how do you know what’s right? What can you truly afford?
Determine What you Can Afford
The first trick is to determine what you can afford. This means in real life, not on paper. For example, let’s say you make $5,000 gross a month. If you apply for an FHA loan, a lender might approve you for a $1,550 monthly mortgage payment. This doesn’t mean you have to take a mortgage payment that high.
Rather than taking what you get approved for, look and see how it fits into your budget. Are you used to making a housing payment around that much? Let’s say you are used to renting and your rent payment was only $900. Spending almost $600 more per month can be a real payment shock. If the jump is too big, consider finding a home that requires a smaller mortgage.
The key is to look at the potential payment and how it pertains to what you are used to spending. Generally, underwriters consider it a red flag when your payment shock exceeds 125%. In the case of the $900 rent payment, underwriters might not consider it an issue until the payment exceeds $1,125. Since this is still below the 31% front-end ratio, you’d be considered a ‘safe borrower.’
This doesn’t mean you must accept a loan with a payment 125% higher than your current payment. You should only accept what you are comfortable with paying. If you don’t consider it a ‘safe payment’ for yourself, find a smaller loan.
Consider your After Tax Income
Lenders use your gross monthly income when they determine how much you can afford. This isn’t the money you bring home, though. This is the money before taxes. If you want a better idea of what you can afford, consider your after-tax income. You can use the same 28% or 31% if you wish, but calculate it off your after-tax income.
Using the $5,000 a month example, let’s say you actually bring home $4,250. Now instead of a $1,550 mortgage payment, a 31% ratio would give you $1,317 payment. Again, this is just on paper. You should figure out if you could afford this payment in real life.
Figure in Your Other Payments
Don’t forget you have other payments to consider. If you have a car payment, student loans, or credit card debt, they take away from your monthly income as well. You need to be able to comfortably afford all of your payments. If your other debts are high, you may want to take a lower mortgage payment. If you need the higher mortgage payment, you may want to try to pay off your other debts. Generally, your total debts, including the new mortgage can’t exceed 43% of your gross monthly income.
On the $5,000 gross monthly income example, that means $2,150 total. If the mortgage payment is $1,550, this only leaves $600 for ‘other debts.’ If they exceed that amount, you will need a lower mortgage payment. Assuming you could fit your $600 debts in with the $1,550 mortgage payment, you’d have $2,100 left after taxes and paying your monthly obligations.
The 28% Rule
As a general rule of thumb, people stick to the 28% rule. This is 28% of your gross monthly income. Using the gross monthly income of $5,000, this means a maximum mortgage payment of $1,400. Remember, this is your full housing payment. This means your principal, interest, taxes, and insurance. While it’s a lower percentage than certain loans allow, it allows you a little wiggle room, giving you room to save money.
Remember, when you own a house, you’ll want an emergency fund. What if an appliance broke or your garage door air conditioning stopped working? You need money to pay for repairs. Having an emergency fund can help keep you out debt as you maintain your home. An emergency fund is also a good idea in case you lose your income for one reason or another. Without your income, you might default on your mortgage. The emergency fund can help prevent that.
Determining wat percentage of income you should spend on a mortgage is a personal decision. Of course, the lender must be in agreement with you so that they approve you. However, you don’t have to take a loan for the full amount a lender approves you for. Basically, they will pre-approve you for the maximum amount of loan you qualify to receive. It’s up to you to decide what is affordable. Sticking to the 28% of your after-tax income can help you stay on track.