How much percent of your income should your mortgage be

You’ve run the numbers to determine how much house you can truly afford. That’s great! But now comes the hard part: actually finding a home that fits into your budget.

Here are some strategies to help stay on budget while searching for your next home.

Buy A Starter House Instead Of A Forever Home

In some cases, your budget might not be able to support your forever home dreams right now. And that’s OK! Instead of hunting in vain for a forever home that checks all of your boxes – including your budget – consider buying a starter home.

A starter home may be a bit smaller, older and closer to an area’s urban center than your dream home. But choosing to move forward with a starter home means that you’ll get into a home sooner and start putting money toward owning a property each month.

Once you, and your finances, are ready for your forever home, you’ll have plenty of options for your starter home. You could convert it into your first rental property to produce an income while upgrading your home. Or you could sell the starter home and funnel any proceeds into the equity of your next home.

Pay Down Your Debt

If you want to increase the amount of house you can afford, then paying down your existing debts can make a big difference. Of course, paying down debt can be easier said than done. But with regular action, you might be surprised by the dent you can make.

If possible, hold off applying for preapproval until you pay down the debts that are within reach. This strategy comes with three major benefits.

First, you’ll have some of the debts holding back your finances cleared from the books. Second, a decrease in your monthly debts will lead to an increase in the percentage of your monthly income that can be allocated towards your mortgage payment.

Finally, paying down debts will increase your overall financial health and potentially increase your credit score, making lenders more willing to approve your loan. Plus, you may even be able to unlock a better interest rate. A lower interest rate means that more of your mortgage payment can go towards your loan's principal, leading to a potentially larger loan amount.

If you are interested in tackling this strategy head-on, then learn how to pay off debt fast.

Wait

Waiting to purchase a home might not be the ideal choice. But time can make all the difference. If you are willing to hold off on your home purchase, many things could change between now and then.

For example, you might find a way to increase your income. That would allow you to qualify for a larger loan. Plus, the increased income would make saving for a larger down payment more feasible.

Additionally, waiting can give you the time you need to pay off your debts. That could significantly impact the amount of home you can afford.

Whether it’s a real estate investment or the purchase of a forever home, buying property is almost always an expensive endeavor. A home purchase is easily one of the largest investments consumers will make in their lifetime, so understanding all the costs involved is crucial.

But when you’re buying a home, it’s important to not only consider the overall cost, but also the monthly costs, as these will help you to build your budget and determine how much home you can really afford. So, if you’re not sure how to determine the right percentage of income for a mortgage, this article is for you!

What Does A Mortgage Payment Include?

To understand how much of your income should go toward a mortgage loan, you first must understand the components that make up a mortgage payment. Each month, a portion of your payment will go toward the following:

• Principal: The principal balance of a mortgage refers to the original sum borrowed to purchase the house.

• Interest: Alongside the principal, the largest component of your monthly mortgage payment is interest, which is the cost you pay the lender in exchange for borrowing money.

• Property taxes: The exact cost of property taxes depends on the location and assessed value of the home.

• Homeowner’s insurance: This type of insurance protects your home against things like accidents and natural disasters.

• Mortgage insurance: If you make a smaller down payment, your lender will also require this type of insurance, which protects their investment in the event that you default on the loan. This could be paid in the form of private mortgage insurance (PMI) or a mortgage insurance premium (MIP), depending on the loan type.

How Much Of Your Income Should Go To Your Mortgage Payment?

To determine how much income should be put toward a monthly mortgage payment, there are several rules and formulas you can use – but the most popular is the 28% rule, which states that no more than 28% of your gross monthly income should be spent on housing costs.

When mortgage lenders review your finances, they utilize the following ratios to determine how much you can afford to borrow.

Front-End Ratio

The front-end ratio – also called the mortgage-to-income ratio – represents the percentage of your monthly gross income that goes toward mortgage costs. This number is calculated by dividing the expected monthly mortgage payment by the borrower’s gross monthly income.

Back-End Ratio

Where the front-end ratio focuses specifically on mortgage costs as they relate to your income, the back-end ratio takes all debt payments into account. This is commonly referred to as the debt-to-income ratio (DTI), which is the percentage of your gross monthly income spent on debt payments including student loans, auto loans, personal loans and so on. This number is calculated by dividing total debt costs per month by the borrower’s gross monthly income.

Percentage Of Income Rules And Guidelines

Although most personal finance experts recommend the 28% rule, there are several other rules and guidelines that can be helpful in your calculations. With the following percentage of income rules, you can feel confident in determining precisely how much to put toward your monthly payments, so let’s get into it.

The 28/36% Rule

The 28%/36% is based on two calculations: a front-end and back-end ratio. As we’ve discussed, this rule states that no more than 28% of the borrower’s gross monthly income should be spent on housing costs – but it also states that no more than 36% should be spent on total debt costs.

To use this calculation to figure out how much you can afford to spend, multiply your gross monthly income by 0.28. For example, if your gross monthly income is $8,000, you should spend no more than $2,240 on a monthly mortgage payment.

The 35%/45% Rule

The 35%/45% rule emphasizes that the borrower’s total monthly debt shouldn’t exceed more than 35% of their pretax income and also shouldn’t exceed more than 45% of their post-tax income.

To use the first part this rule, you’ll need to determine your gross monthly income before taxes and multiply it by 0.35. For the second part, multiply your monthly income after taxes by 0.45.

The 25% Rule

The 25% rule allows borrowers to use their net income in calculations, which may be easier for borrowers who are unsure about their gross monthly income. This rule states that no more than 25% of your post-tax income should go toward housing costs.

To follow this model, multiply your monthly income after taxes by 0.25.

What Do Lenders Look At To Determine Your Home Affordability?

Lenders look at several factors when determining whether a borrower will qualify for home financing, including the following:

• Income: Your gross income includes all wages and other earnings before taxes. Your income helps lenders determine whether you can afford to purchase a home.

• Credit score: Your credit score helps the lender analyze the risk associated with lending you the money to buy a house. Precise credit score requirements depend on the loan type and lender, but in general, you’ll need a score of at least 620 for a conventional loan.

• Debt: Your debt-to-income ratio shows how much you earn compared to how much a mortgage would cost. Lenders use this to see how easily you would be able to afford a monthly mortgage payment.

• Down payment: Though not everyone can afford to put 20% down, a larger down payment will mean a lower monthly mortgage payment.

How To Lower Monthly Payments

In running these percentage of income calculations, you may realize that you can’t afford the monthly payment on your ideal home. But don’t fret! While you may not be able to directly control your income, there are other strategies you can use to lower your monthly mortgage payments.

Improve Your Credit Score

Higher credit scores mean better loan terms, including a lower interest rate, so taking action to improve your score is always a good idea before applying for a mortgage. Paying your bills on time can improve your score and paying off extra debt can also improve your debt-to-income ratio.

Make A Larger Down Payment

As we’ve mentioned, larger down payments often mean lower monthly payments, so consider taking the extra time to save for upfront costs if it means affording a larger down payment. And as a bonus, a higher down payment (at least 20%) will also allow you to avoid paying for mortgage insurance.

Change Your Loan Term

Another option is to lengthen your loan term. By making the loan term longer, you’re spreading your principal balance across a longer period of time, making monthly payments cheaper, even if it means paying more in interest over the lifetime of the loan.

The Bottom Line

When you’re preparing to buy a home, it’s important to consider the overall costs alongside the monthly costs to ensure you’re not biting off more than you can chew financially. Using a percentage of income rule and calculation, you can feel more confident in precisely how much home you can afford to buy.

If you’re ready to take the next step toward homeownership, apply for a mortgage and get started!