Finance

How Much of Your Income Should Go to Mortgage?

August 12, 2022

If you’re considering buying a home or changing careers, your financial planning questions probably include how much of your monthly income should go to mortgage loan payments.

First-time homebuyers are often surprised at how much they can be pre-approved for, and it’s easy to think of that number as a housing cost rule of thumb—after all, it’s what the bank thinks you can afford, right?

Safe and smart budgeting guidelines, however, will put your target mortgage payment below your maximum buying power. This way, you don’t need to find out what happens if you miss a mortgage payment. Let’s take a look at the factors involved in deciding how much to spend on home loan payments.

Mortgage Payment Amounts Based on Income and Debt

Assuming you don’t have a fat pile of cash hidden in your mattress, your debt planning is in relation to your current and anticipated annual income.

If you work a nine-to-five with a set salary, the “income” line in your budget is pretty simple to fill out. However, you’ll need to come up with an accurate and realistic annual income record and projection if you:

Work seasonally
Have multiple wage-based jobs
Are a freelancer
Own a business
Have supplemental income sources

How Do You Calculate Your Debt to Income Ratio?

Once you know your income, your debt-to-income (DTI) ratio is expressed as a percentage calculated by dividing total monthly debt with monthly gross income (what you earn before taxes or other deductions are taken out).

Monthly debt payments include anything you’re making a regular monthly payment on, such as:

Car loans
Monthly mortgage payment or rent
Student loans
Credit card payments (use the minimum monthly payment or your average payment)

For example, if you earn $4,000 per month and pay $1,200 in rent, $400 for a car loan, and $400 in student loans, your DTI ratio is 50% (2000 ÷ 4000 = 0.5; 0.5 x 100 = 50). This, unfortunately, is a pretty high DTI ratio, although you’d still qualify for an FHA loan or a loan amount from some mortgage lenders with less-than-ideal terms and interest rates.

How Much Should Go to Mortgage?

Many mortgage lenders limit DTI to 43%, including housing costs. This means if you carry little other debt, you could end up spending nearly half of your income on a mortgage payment.

Financial planners, however, recommend sticking to 25% max as your monthly housing expense payment, whether that’s mortgage or rent.

How Much Will Lenders Approve?

Lenders are balanced between giving a “no” if they think a borrower cannot repay a loan and an enthusiastic “yes” to borrowers who look like a good bet. While it can feel like you’re on the same team in terms of avoiding a loan you can’t afford, don’t forget that they’re in business to make money off of your mortgage rate.

The best outcome for a mortgage lender is the biggest loan you can repay, regardless of how else that affects your financial future. They’ll use your current DTI ratio as a key guideline to:

Qualify you for a mortgage loan
Determine the interest rate and terms offered
Determine the pre-approval maximum and loan amount

For a loan with the best terms, most lenders look for a DTI ratio under 36%, of which the mortgage payments should comprise no more than 28%.

Additional Costs to Consider

Whether you’re buying for the first time, considering a remortgage, or purchasing a new home, you need to allow for the additional and unexpected costs involved in home ownership. These may include:

Desired renovations, such as replacing carpet with hardwood or installing a privacy fence
Repairs to structural elements that weren’t caught during the inspection
Upcoming life expectancy expiration of construction components and appliances
Closing costs, agent commissions, and appraisal, inspection, and filing fees
Moving labor, equipment, and transport (plus incidental damage or loss)
Time away from work

How to Reduce Your Mortgage Payments

Once you determine how much of your pre-tax income should go to a mortgage, you may want to consider how to reduce your monthly housing payments. Odds are you probably don’t want to find out the hard way what happens if you can’t pay your mortgage.

For a new property purchase, you can:

Get a better loan offer by improving your credit score and/or reducing your debt load
Make a down payment of 20% or more to avoid private mortgage insurance (PMI)
Opt for a longer term on a mortgage
Choose a lower-cost property by prioritizing and differentiating your needs and wants
Compare multiple lender quotes
Work with a mortgage broker
Negotiate with lenders

For smaller payments on a current home, you could:

Increase your equity level to get rid of PMI
Refinance to better terms, including a lower monthly mortgage payment
Extend the life of your loan
Communicate and negotiate with your mortgage lender
Work with a nonprofit credit score counseling organization

Avoid Higher Monthly Payments by Using Your Equity

If you need to tap into home equity to pay off mortgage or invest in other costs such as education, medical bills, or remodeling, a common method is to take out a second mortgage or home equity loan—but this leads to higher monthly loan payments.

There’s an alternative option available that lets you convert your equity to cash without higher mortgage payments or the hassle of qualifying for and negotiating a loan offer. Sale-leaseback solutions let homeowners convert the equity they already own into cash. You sell your home and stay in it as a renter until you’re ready to move or repurchase.

Key Takeaways

A home isn’t just a burden to your monthly budget—it’s an investment that grows, and you have the right to take advantage of the funds you’ve built at any time, not just when you move out.

Talk to a financial advisor today to consider all of your options and figure out what will work best for you.

Sources:

Consumer Reports. Here’s How Much Mortgage You Can Actually Afford. https://www.consumerreports.org/mortgages/how-much-mortgage-can-you-afford/

Investopedia. What Constitutes a Good Debt-to-Income (DTI) Ratio? https://www.investopedia.com/ask/answers/081214/whats-considered-be-good-debttoincome-dti-ratio.asp