July 12, 20235-minute read
Author: Katie Ziraldo
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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:
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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. 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. 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.Front-End Ratio
Back-End Ratio
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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% 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 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 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.The 28%/36% Rule
The 35%/45% Rule
The 25% Rule
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:
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. 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. 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. 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.Improve Your Credit Score
Make A Larger Down Payment
Change Your Loan Term
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!
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