What’s the Ideal Income to Mortgage Ratio?
This is a crucial question, especially for first-time homebuyers, seeking the right balance as they step into homeownership. Much like other significant financial choices, the aim is to seamlessly integrate your monthly mortgage payment into your lifestyle.
Morty steps in to guide you in calculating a comfortable income to mortgage ratio, ensuring you make an informed decision about your mortgage expenses. In this comprehensive guide, we’ll dissect the components of a mortgage payment and explore various mortgage payment models, equipping you with the knowledge to navigate the mortgage shopping process. Furthermore, we’ll demystify how lenders assess your affordability and explore strategies for potentially reducing your mortgage payments.
What is a Mortgage Payment?
You might know that a mortgage payment refers to the amount you pay monthly toward your mortgage loan. However, you can break up a mortgage payment into four ongoing parts: principal, interest, taxes, homeowners insurance and possibly mortgage insurance. Let’s take a look at each individual part.
- Principal: The principal of your mortgage refers to your total loan balance — the amount you have left until you completely pay off your loan. For example, let’s say you borrow $200,000 to buy a house. The principal amount is $200,000. When you pay off $50,000 of your loan balance, your principal amount is $150,000. When you make principal payments over time, you reduce the amount you owe.
- Interest: Your mortgage lender charges you for borrowing money in the form of interest. The amount you pay per month in interest depends on the interest rate you receive from your lender.
- Taxes: Property taxes pay for local government needs, such as road maintenance, libraries, schools and police protection. Typically, when taxes are part of your mortgage payment, a third party holds these funds in an escrow account. In this case, your mortgage servicer pays your taxes for you, though you may also have the option to request to waive escrow and pay for these expenses yourself when they are due.
- Homeowners insurance: Every homeowner who has a mortgage must have homeowners insurance coverage. Homeowners insurance covers home loss and damage due to fire, wind, theft or other hazards. A portion of the money held in your escrow account goes toward paying for homeowners insurance.
- Mortgage insurance: For a conventional loan, if you make a down payment of less than 20%, you’ll pay for private mortgage insurance (PMI). Mortgage insurance protects your lender in case you stop making payments on your mortgage.
Mortgage Payment Rules and Methods
So, how do you calculate how much you can afford per month for mortgage payments?
You can use mortgage calculation methods to help you gauge how much of your income should go toward your mortgage. The calculation depends on your personal income, other financial goals and debts. Let’s take a look at a few calculations you can use:
- The 28% rule: The 28% rule specifies that your mortgage payment shouldn’t be more than 28% of your monthly pre-tax income. To find your maximum mortgage payment with the 28% rule, multiply your monthly income by 28%. Let’s say you have a monthly income of $6,000. In this case, you would calculate:
$6,000 x 0.28 (28%) = $1,680 (maximum mortgage payment).
In a more thorough examination of the 28% rule, you could also calculate the 28/36 rule, which states that your mortgage payment shouldn’t be more than 28% of your monthly pre-tax income and 36% of your total debt.
- The 35%/45% model: The 35%/45% model says that your total monthly debt, including your mortgage payment, shouldn’t be more than 35% of your pre-tax income, or 45% more than your after-tax income. To calculate it, multiply your gross monthly income before taxes by 35%. Next, deduct your taxes from your gross monthly income and multiply by 45%. You can pay special attention to the range between these two figures.
Let’s say you make $7,000 before taxes and $5,000 after taxes. Your calculation will look like this:
$7,000 x 0.35 (35%) = $2,450
$5,000 x 0.45 (45%) = $2,250
Based on the calculation, you can afford a mortgage payment between $2,250 and $2,450 per month.
- The 25% post-tax model: In this model, your total monthly debt should amount to 25% or less of your post-tax income. In other words, multiply the money you make after taxes by 25%. Let’s say you make $6,000 after taxes:
$6,000 x 0.25 (25%) = $1,500
This model suggests that you can afford a mortgage payment of $1,500 per month.
Is one model better than the other? No, not necessarily.
Keep in mind that these numbers only serve as a guide; you should evaluate each set of calculations against your own personal situation.
How Do Lenders Determine What I Can Afford?
Lenders determine how much house you can afford by taking into account your gross income, debt to income ratio (DTI) and credit score. Take a look at the guidelines you can consider below:
- Gross income: Your lender will need to know how much you earn. You’ll need to provide current pay stubs, W2 forms or tax records, for example.
- Debt-to-income ratio: Your DTI ratio refers to your monthly debt payments divided by your monthly gross income. You can calculate it yourself by adding up your fixed monthly debt payments, such as rent, student loans, auto loans — any payments that don’t vary each month. Next, divide your monthly bills by your gross monthly income (income before taxes) to arrive at your DTI ratio, also called your front end ratio. It’s beneficial to keep your DTI ratio as low as possible when shopping for a mortgage. Lenders generally require a DTI ratio below 43%.
- Credit score: Your credit score is a three-digit number that can range from 300 to 850 and is an indicator of how well you pay back debt. Various types of home loans require different credit scores. For example, if you get a conventional loan, which is a loan not backed by a government entity, you should have a credit score of at least 620. On the other hand, you will need at least a 500 credit score with a 10% down payment for an FHA loan, a loan backed by the Federal Housing Administration. You’ll need a 580 credit score to qualify for a the 3.5% low down payment advantage.
Tips for Lowering Your Monthly Mortgage Payments
When you want to lower your monthly mortgage payments, you have a few options at your disposal. Let’s take a look at some possibilities, especially if you believe too much of your income is currently going or will go toward your mortgage payments.
Lengthen Your Mortgage Term
Instead of choosing a shorter mortgage term, you might want to opt for a lengthened mortgage term. For example, you may consider choosing a 30-year fixed-rate mortgage instead of a 15-year fixed-rate mortgage. (Use our article about how to calculate a mortgage payment to learn how to calculate the difference.)
Let’s say you borrow $200,000 to buy a home with an interest rate of 4%. Your mortgage payment would be $955 per month over the course of 30 years (without taxes and insurance).
Now, let’s say you keep the same loan amount and interest rate and consider a 15-year mortgage instead. You’d pay $1,479 per month (without taxes and insurance included).
Lengthening your mortgage term can make a big difference in how much you pay per month, though keep in mind that you’ll also pay interest for a longer period of time.
Increase Your Credit Score
Increasing your credit score can help you get more favorable mortgage terms, including a lower interest rate. How do you increase your credit score? You can consider the following:
- Pay off outstanding debt, including credit cards or student loans.
- Pay your bills on time.
- Steer clear of applying for too much credit, particularly before you apply for a mortgage loan.
- Have a good credit mix, which means having a wide variety of credit types.
Make a Larger Down Payment
Putting down a larger down payment may lower your interest rate and mortgage payment. Lenders generally consider a larger down payment to be a sign of a less risky borrower.
Eliminate Private Mortgage Insurance
If your down payment is less than 20% , you’ll make extra payments to protect your lender. This is called private mortgage insurance (PMI). However, eliminating PMI reduces your mortgage payment.
Lenders typically allow you to request PMI cancellation when your principal loan balance reaches 80%. By law, your lender must remove it when your principal loan balance reaches 78% of the original value of your home.
Refinance Your Mortgage
Refinancing your mortgage can be a great way to lower your mortgage payments. Refinancing means you exchange your old mortgage for a new one. Your bank or lender pays off your old mortgage and replaces it with a new loan.
Refinancing can give you the opportunity to lower your interest rate, lower or extend your mortgage term or turn your home’s equity into cash.
Request a Home Tax Reassessment
If you find that your home’s assessed value is considerably higher compared to other homes in your area, you may be able to appeal it and save money. The assessment should be based on the market value of your home. Appealing through your local assessor’s office could reduce the amount you spend on taxes and reduce your monthly mortgage payments.
Want to take a look at personalized mortgage options? Let Morty help you get started.
This post was updated on Feb. 28, 2022.