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.
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.
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