What Percentage of My Income Should I Spend on a Mortgage?
By Brandon Cornett | © 2014, all rights reserved | Duplication prohibited
Reader question: "I am in the market to buy a house and am very concerned about affordability. I'm trying to determine what percentage of my income I should spend on a mortgage loan. I've been researching this online, but there seem to be many different recommendations in this area. Is there a general rule of thumb as to what percentage of your income should go toward housing costs?"
There are two reasons you've seen so much variation on this theme:
1. Different concepts, different numbers.
Lenders typically have a limit for the percentage of income you can put toward the mortgage. This is referred to as the debt-to-income ratio, or DTI. Financial advisors and consumer advocates often recommend a lower number that takes other factors into account, such as retirement savings, entertainment expenses, and overall quality of life. These folks often recommend a lower percentage of income for house payments, such as 25%. Under the 25% "rule," you would use no more than 25% of your income for home loan payments.
But these are two different numbers. The lender's limit has to do with mortgage approval. The 25% recommendation, and others like it, have to do with affordability. Affordability and approval are two different things.
2. There are no hard-and-fast rules.
What percentage of your income should you spend on a mortgage? It really comes down to how much debt you are comfortable carrying. For instance, some mortgage lenders will approve borrowers with front-end debt ratios of 30% or higher. This means the borrower's mortgage payments use 30% of gross monthly income. Some borrowers are comfortable spending that much of their income on mortgage payments. Others are uncomfortable with anything over 25% (and frankly, I don't blame them).
Percentage of Income for Mortgage Payments
That explains why there are so many "rules" and recommendations regarding the percentage of income you should use for a mortgage. Let's move on to talk about the two qualifying ratios lenders use when considering borrowers for a loan. As a borrower, you have two different debt-to-income (DTI) ratios. One is a comparison between your income and your monthly mortgage expense. The other one takes all of your monthly debts into account.
Here's the difference:
- Front-end DTI ratio. Your front-end ratio is basically the percentage of your income that goes toward your housing costs. In this context, your housing costs include everything that makes up your monthly mortgage payments (principal, interest, homeowners insurance, property taxes, and sometimes mortgage insurance). This is the ratio that applies to your question. We will talk more about front-end DTI limits below.
- Back-end DTI ratio. Also known as the total debt ratio, the back-end DTI is a comparison between monthly income and total monthly debts. This ratio shows the percentage of income you are using to cover all of your recurring monthly debts. It includes the mortgage payment, plus all other debts you pay each month, such as car loans, student loans, credit cards, child support and alimony, etc.
The front-end debt-to-income ratio is the one that shows the percentage of income you are spending on mortgage costs. So that's the one we should focus on here. But remember, these ratios have more to do with mortgage approval than affordability. You should establish your own housing budget based on your specific financial situation and goals. But for now, let's stick with the basic requirements for approval.
For a conventional home loan (one that is not insured by the government), mortgage lenders typically cap the front-end DTI ratio somewhere between 28% and 30%. That is the maximum percentage of income that can go toward mortgage payments. Again, this is just a rule of thumb used by most lenders -- it's not set in stone. Some lenders will allow a higher percentage to go toward monthly payments. But the 28% "rule" has long been a standard within the lending industry.
For an FHA home loan, lenders generally allow for a higher front-end debt ratio. The FHA program is managed by the Department of Housing and Urban Development (HUD). So let's start with the minimum HUD guidelines.
According to HUD Handbook 4155.1, Chapter 4, Section F, the monthly payments are "considered acceptable if the total mortgage payment does not exceed 31% of the gross effective income." In other words, your monthly payment on the home loan should not use up more than 31% of your gross monthly income -- gross meaning before taxes are taken out.
But there are exceptions to this FHA rule, as well. Lenders may allow a higher percentage of your income to be used for mortgage payments if they can identify "significant compensating factors." You'll find a list of these compensating factors in the HUD handbook mentioned above. Compensating factors might include a history of making mortgage payments equal to or greater than the proposed payments on the new loan, or a down payment of 10% or higher.
How Much Debt Are You Comfortable with?
In the previous section, we talked about the various DTI rules that limit the percentage of income that can be applied to mortgage payments. Your financial comfort-zone may lie below these numbers. You may not be comfortable spending 28% or 30% of your gross monthly income on housing costs. So there are some personal decisions to be made here, as well. The lender's requirements are one thing. Your lifestyle and your financial goals are something else entirely.
We always encourage borrowers to start this process by creating a basic housing budget. Put all of those percentages aside for a moment. Take a look at the amount of money you earn each month, and the amount you spend on all of your monthly expenses. Be sure to include your entertainment expenses, savings account contributions, and emergency planning.
You never want to stretch yourself so thin to the point of wiping out your entire paycheck every month. This would leave you without a financial buffer for emergencies. Financial advisors typically recommend maintaining an emergency fund equivalent to at least three months of expenses.
What if you lost your job and had to scramble to find another? What if you had some unforeseen medical expenses? What if your refrigerator suddenly died and had to be replaced? These are scenarios where it's helpful to have some extra money in the bank. That's why you should limit the percentage of your income you spend on your mortgage to an amount that leaves something over each month.
Here's the best-case scenario. Ideally, you should be able to cover your mortgage payments, cover all of your other debts, have a little fun, put a little money aside in your savings account, and still have some cash left over each month. You'll have to do some math to find out what percentage this comes out to. It might be 20%. It might be 25%. It might be higher than that.
You might even find that it's easier to ignore the percentages entirely. If you follow the steps outlined in the "what can I afford" article above, you won't even need a percentage. You'll have a monthly dollar-amount spending limit instead. Some people find this is a better way to handle the budgeting process.
Disclaimer: This article answers the question, What percentage of my income should I spend on a mortgage loan? Despite the length of this tutorial, we have only scratched the surface. There are other factors to consider as well. This article is provided for educational purposes and does not constitute financial advice. Budgeting for house payments is a personal and individualized process. Different borrowers have different comfort levels, in terms of the amount of debt they carry. You should not feel obligated to spend a certain percentage of your income on mortgage payments, just because of some arbitrary rule of thumb you found on the Internet. Create a housing budget for yourself, using real dollar amounts instead of percentages. This will reduce the chance of financial hardship down the road.
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