Whether you’re a first-time homebuyer or on the hunt for your dream home, purchasing a house can be a costly endeavor. From the price of the home to various expenses like down payments and mortgage rates, there are many factors that can impact your monthly mortgage payment. Your income also plays a crucial role in determining the house you can afford. Mortgage companies typically restrict the percentage of your gross income that can go towards housing, so it’s important to understand the guidelines. In this guide, we will break down everything you need to know about affording a mortgage for a home in your desired price range and discuss common rules of thumb to keep in mind.
Understanding what mortgage payments include
Before delving into the percentage of income that should go to a mortgage, it’s important to understand the components of a mortgage payment. A typical mortgage payment consists of more than just principal and interest. Here’s a breakdown of what may be included in your monthly housing payment:
- Principal payment: This portion of your payment is allocated towards paying down the principal amount of your loan, following an amortization schedule based on the loan term.
- Mortgage interest: Your payment also includes the interest charged on the loan, which depends on the mortgage interest rate and the loan term.
- Homeowners insurance: If you have an escrow account, a portion of your monthly payment will go towards homeowners insurance. The account will pay this bill on your behalf once a year.
- Property taxes: Similarly, if you have an escrow account, a portion of your payment will cover your property taxes. The institution maintaining your account will pay this bill on your behalf.
- Mortgage insurance: If you put down less than 20% or have a certain type of home loan, you may be required to pay mortgage insurance each month.
Percentage of income rules: How much income should go to mortgage payments
Mortgage companies have their own rules that restrict the amount you can borrow based on your income and other factors. However, it’s advisable to set your own limits to avoid any financial strain. There are two key terms to understand: front-end ratio and back-end ratio. The front-end ratio refers to your monthly housing payment, including principal, interest, taxes, and insurance. The back-end ratio takes into account all your other debts.
Here are some common rules of thumb for housing payments:
28% rule
According to this rule, your housing payment should not exceed 28% of your gross income. If you and your spouse earn a total gross income of $10,000 per month, your full housing payment should be no more than $2,800.
28% / 36% rule
This rule considers both your housing payment and your back-end ratio. Your housing costs should not exceed 28% of your gross income, and your total debts each month should not exceed 36% of your gross income. For example, with a gross monthly income of $10,000, your housing payment should be no more than $2,800, and your total debts should not exceed $3,600.
35% / 45% rule
Similar to the previous rule, this one takes into account your gross and net income after taxes. Your housing payment should not exceed 35% of your gross income or 45% of your net income. For instance, if your gross monthly income is $8,000, your housing payment should be no more than $2,800 and no more than $2,925 based on your post-tax monthly income.
25% post-tax rule
Some homebuyers prefer to use only their after-tax income. According to this rule, no more than 25% of your after-tax income should go towards housing costs. If you bring home $8,000 per month after taxes, your full housing payment should be no more than $2,000.
How do lenders decide what you can afford?
While the percentage of income rules mentioned above are commonly used by homebuyers, lenders have their own criteria to determine eligibility. The type of home loan you apply for can also impact these factors. Lenders typically consider the following criteria:
- Credit score: Your credit score affects the type of mortgage you qualify for and the interest rate. Most lenders require a minimum credit score of 620 for a conventional mortgage.
- Debt-to-income ratio: The amount of debt you have in relation to your income influences your mortgage eligibility. Lenders may consider both front-end and back-end ratios.
- Down payment: The size of your down payment determines how much you can borrow. A larger down payment means a smaller loan amount.
- Income: Lenders assess your income to determine your affordability for a home. Higher income usually allows for a larger borrowing capacity.
How to lower your monthly mortgage payments
Regardless of the price range you’re shopping in, there are steps you can take to lower your monthly mortgage payment:
Increase your credit score
Boosting your credit score can qualify you for a wider range of loan options with better rates. A higher credit score, such as “very good” (740-799) or “exceptional” (800+), can help you secure a lower rate.
Save up a bigger down payment
Saving a larger down payment can lead to a lower mortgage amount and consequently, a lower housing payment. It also enables you to avoid private mortgage insurance (PMI).
Change your loan term
Choosing a longer-term loan, such as a 30-year fixed-rate mortgage, can result in a lower monthly payment. Alternatively, you can consider an adjustable-rate mortgage (ARM) to take advantage of a low teaser rate initially.
Homebuyer costs to consider
Apart from your monthly housing payment, there are several other expenses associated with buying and owning a home. These costs include:
- Savings for a down payment
- Regular maintenance and upkeep
- Costs for home inspection
- Replacement of major components (e.g., roof, HVAC system, water heater)
- Lawn care and landscaping
- Prepaid costs at closing (property taxes, homeowners insurance, etc.)
- Home improvements and projects
- Moving and relocation expenses
- Furniture, window coverings, and decor
Frequently asked questions (FAQs)
How do I calculate a down payment amount?
To calculate your down payment, multiply the home purchase price by the percentage required for a down payment. For example, if you want to purchase a $300,000 home and your FHA loan requires a 3.5% down payment, your down payment amount would be $10,500.
How much will I pay with a Federal Housing Administration (FHA) loan?
FHA loans require a minimum down payment of 3.5% if your credit score is above 580. If your credit score falls between 500 and 579, you may need to save a 10% down payment.
How much will I pay with a U.S. Department of Agriculture (USDA) loan?
USDA loans offer the opportunity for 100% financing, meaning no down payment is required. Your monthly housing payment will depend on the mortgage interest rate and loan amount.
How much will I pay with a Veterans Affairs (VA) loan?
VA loans also offer 100% financing, with no down payment needed. Similar to USDA loans, your mortgage payment will depend on the interest rate and loan amount.
How much existing debt can I have and still qualify for a mortgage?
Eligibility for a mortgage depends on various factors that differ by loan type. However, you may qualify for a conventional mortgage with a debt-to-income ratio as high as 50%.
What mortgage options are available?
You can choose from a range of home loans, including conventional mortgages, FHA loans, VA loans, USDA loans for rural housing, and more.
For more information on personal finances, visit Personal Finances Blog. Happy house hunting and stay financially savvy!