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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As an expert in real estate and personal finance, I bring a wealth of knowledge and experience to guide you through the complexities of buying property and managing mortgage payments. My expertise is grounded in a deep understanding of the concepts and principles discussed in the article written by Katie Ziraldo on July 12, 2023.
The article highlights the significance of thoroughly understanding the costs associated with buying a home, emphasizing that it is one of the most substantial investments individuals will make in their lifetime. It stresses the importance of considering both the overall cost and the monthly costs to build a budget and determine the affordability of a home.
Concepts Covered in the Article:
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Components of a Mortgage Payment:
- Principal: The original sum borrowed to purchase the house.
- Interest: The cost paid to the lender for borrowing money.
- Property Taxes: Variable costs depending on the location and assessed value of the home.
- Homeowner’s Insurance: Protection against accidents and natural disasters.
- Mortgage Insurance: Required if the down payment is smaller, protecting the lender in case of default.
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Determining Mortgage Affordability:
- 28% Rule: Recommends that no more than 28% of gross monthly income should be spent on housing costs.
- Front-End Ratio: Focuses on the mortgage-to-income ratio, calculated by dividing the expected monthly mortgage payment by gross monthly income.
- Back-End Ratio (Debt-to-Income Ratio): Considers all debt payments, including student loans and auto loans, in addition to housing costs.
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Percentage of Income Rules and Guidelines:
- 28%/36% Rule: Limits housing costs to 28% and total debt costs to 36% of gross monthly income.
- 35%/45% Rule: Caps total monthly debt at 35% of pre-tax income and 45% of post-tax income.
- 25% Rule: Allows using net income, stating that no more than 25% of post-tax income should go toward housing costs.
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Factors Considered by Lenders:
- Income: Gross income is assessed to determine the ability to afford a home.
- Credit Score: A crucial factor affecting loan terms, with a recommended score of at least 620 for a conventional loan.
- Debt: Debt-to-income ratio is evaluated to assess the ability to afford a monthly mortgage payment.
- Down Payment: While not mandatory, a larger down payment can result in a lower monthly mortgage payment.
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Strategies to Lower Monthly Payments:
- Improve Credit Score: Higher scores lead to better loan terms, including lower interest rates.
- Larger Down Payment: A higher down payment can lower monthly payments and eliminate the need for mortgage insurance.
- Change Loan Term: Lengthening the loan term spreads the principal balance over a longer period, reducing monthly payments.
In conclusion, understanding these concepts and applying the recommended rules and guidelines will empower you to make informed decisions when purchasing a home, ensuring financial stability and responsible budgeting.