These questions are often asked by first-time homebuyers:
- What percentage of my monthly income can I afford to spend on mortgage payments?
- Does this percentage include property taxes, private mortgage insurance (PMI), or homeowners insurance?
Today I will answer these questions to make your home buying a little easier.
Consider Your Total Housing Payment, Not Just Your Mortgage
Most agree that your housing budget should include not only your mortgage payment (or rent, for that matter), but also property taxes and all kinds of insurance related to housing – homeowner insurance and PMI.
What percentage of your income should this housing budget be? It all depends on who you ask.
What others say
Traditional model: 35% or 45% of income before tax
In an article about how the mortgage crash of the late 2000s changed the rules for homebuyers for the first time, the New York Times reported:
“If you’re determined to be truly conservative, don’t spend more than 35% of your pre-tax income on mortgage payments, property taxes, and home insurance. Bank of America, which adheres to the principles set by Fannie Mae and Freddie Mac, will allow your total debt (including student and other loans) to reach 45% of your pre-tax income, but no more.”
I wouldn’t call 35% of your pre-tax income conservative, let alone “genuinely conservative”.
Let’s remember that even in the post-crisis world of lending, mortgage lenders want to approve creditworthy borrowers for the highest possible mortgage. So when you get mortgage pre-approval, lenders will likely approve the loan amount for you, with payments up to 35% of your pre-tax income. This may tempt you to take on more of the house than you should. But don’t think that because the bank has approved it, you can afford it. These are two very different things.
Remember, the more you spend on your home, the less money you have left for everything else. Today you can afford to pay 35% of your pre-tax income for housing, but what if you have kids, buy a new car, or lose your job?
Conservative model: 25% after-tax income
On the other hand, debt-scorning Dave Ramsey wants your housing payments (including property and insurance taxes) to be no more than 25% of your after-tax income.
“Your mortgage payment must not exceed 25% of your salary, and you must get a 15-year or less fixed-rate mortgage… Now you can probably qualify for much more credit than that 25% salary will give you. But it’s really unwise to spend more on a house, because then you’ll be what I call a “housewife.” Too much of your income will go to payments and it will put a strain on the rest of your budget so you won’t save and pay cash for furniture, cars and education.”
Note that Ramsey is talking about 25% of your after-tax income, while lenders are talking about 35% of your income before tax. This is a huge difference! Ramsey also recommends 15-year mortgages in a world where most buyers take out 30-year mortgages. That’s what I would call conservative.
Another reader put it this way:
- Your mortgage payment must be equal to one week’s salary.
- Your mortgage payment plus all other debts must not exceed two weeks’ salary.
This is also on the conservative side. A one week salary is about 23% of your monthly (after tax) income.
My opinion: somewhere in between
Not everyone dislikes debt as much as Ramsey. And his universal advice could prevent a large portion of Americans from ever realizing their own home dreams.
Good luck finding a California mortgage that you can repay within 15 years, with monthly payments of less than 25% of your after-tax income. Such an approach would be unrealistic in a number of regional housing markets in the Americas with high home prices.
If I were to set a rule, it would be like this:
- Aim to keep your mortgage payment at or below 28% of your monthly pre-tax income.
- Keep your total debt payments at or below 40% of your monthly income before taxes.
Please note that 40% should be the maximum. I recommend aiming to keep total debt at a third of your pre-tax income, or 33%.
As some commentators have noted, while it is possible to buy a decent house in a small Midwestern town for $100,000 (and well within those ratios), buyers in New York or San Francisco will have to spend five times that amount. only to get a hole in the wall. Yes, people tend to earn more in these high cost of living areas, but not by much. Does this mean they shouldn’t buy a house? Not necessary. They will just have to compromise to buy in those areas.
How to lower your mortgage payment
Extend your mortgage
Choosing a longer mortgage term spreads the loan balance over more total payments, reducing the amount of each individual payment.
But remember, extending the term is expensive, as you will end up paying more in the form of cumulative interest over the life of the loan.
Read more: 15 year mortgage vs 30 year mortgage
Make a larger down payment
The larger your down payment, the more capital you will start with your home, and the smaller the loan amount. Less credit = lower monthly payments.
Also, breaking the 20 percent threshold down means you don’t have to pay PMI, further reducing your total housing costs.
Get the best interest rate
The interest rate your lender offers you affects your monthly mortgage payment. If you get a lower rate, you will make a smaller monthly payment. Your chances of getting the best interest rate can increase in several different scenarios:
Average interest rates are low
Average mortgage interest rates fluctuate significantly from year to year, sometimes fluctuating by as much as 2% in as little as a six-month period.
Getting a fixed-rate mortgage at a time when interest rates are low can lower your monthly payments.
Read more: Briefly about mortgage rates
Your credit score increases
One surefire way to get a better interest rate is to improve your credit score. If you haven’t applied for a mortgage yet and your score can be improved, it might be worth waiting six months or so for your credit score to improve before going for a mortgage.
If you already have a mortgage and your credit score has improved significantly since you first took out a loan, you can refinance it at a better rate.
Read more: How important is a 1% difference in your mortgage rate?
Do you shop around
There are a bunch of options out there for mortgage lenders. Signing a contract with your historic bank may give you the comfort and trust of familiarity, but it won’t necessarily give you the lowest rate you can find.
Always compare your bank’s offer with competing banks, credit unions, and reputable online lenders.
Finding the right lender
One place to start from Credible, a site that allows you to get quotes from three lenders in just three minutes. There is no obligation, but if you see a rate you like for your mortgage or refinancing your mortgage, you can move on to the next step of the application process. Everything is done through the site, including uploading documents. If you want to talk to a loan officer, you can, of course, but it’s not required.
When choosing a lender, remember that every dollar counts. You agree to make a monthly mortgage payment based on the rate you chose at the outset. Even a small savings in interest rate will add up over the years you spend in your home.
fiona This is another great place to start as they allow you to shop and compare multiple rates and quotes with minimal information, all in one place. You enter the loan amount, your down payment, condition, type of mortgage product, and your credit score to get mortgage quotes from multiple lenders at the same time.
Frequently asked Questions
Can I get a mortgage if I have debt?
Having a certain amount of debt—like a car loan—does not make you eligible for a mortgage. But your DTI (debt-to-income ratio) will certainly affect how a lender evaluates your loan application. Generally speaking, a lender will not approve your mortgage if your DTI is above 43%.
Personally, I advise you to hold off on mortgages until your DTI is below 40% max. And 33% DTI is an even better target before applying for a mortgage. A mortgage with a lower DTI gives you more financial breathing room for unexpected expenses.
What is a “house of the poor”?
A poor home is a financial circumstance in which the mortgagee allocates too much of their income to home ownership expenses. This deprives the mortgagee of the opportunity to live comfortably, and also exposes him to the risk of being unable to achieve other financial goals.
Some financial gurus may say that the less of your income you spend on mortgage payments, the better. But being overly conservative with mortgage payments can burden you with a home or neighborhood that you’re unhappy with. On the other hand, allocating too much of your income to mortgages can put you in a financially vulnerable position with little spending income.
My general principle is to keep your monthly mortgage payment, including insurance and property taxes, at 28% of your pre-tax income. And try to keep your total debt payments, including mortgages, as close to 33% of your pre-tax income as possible.
In fact, there is no one-size-fits-all mortgage budgeting solution. But you can start with my average approach and tailor it to suit your future financial goals and your local housing market.
Credible Operations Inc. NMLS #1681276, “Reliable”. Not available in all states. www.nmlsconsumeraccess.org.
Reliable disclosure of credit information – To check the rates and terms you are eligible for, Credible or our partner lender(s) will run a preferential credit pull that will not affect your credit score. However, when you apply for a loan, your full credit report will be requested from one or more consumer information agencies, which is considered hard credit and will affect your credit.