If you’re a first-time home buyer, you might run into trouble deciding how much home you can afford. One of the biggest hurdles that first-time buyers face is calculating how much money they can afford to spend on their mortgage each month.
You might have heard that you should spend about 28% of your gross monthly income on your mortgage. But is this percentage right for everyone? Let’s take a closer look at how much of your income should go to your mortgage.
The 28% Rule
The often-referenced 28% rule says that you shouldn’t spend more than that percentage of your monthly gross income on your mortgage payment. Gross income is your total household income before you deduct taxes, debt payments and other expenses. Lenders typically look at your gross income when they decide how much you can afford to take out in a loan.
Using the 28% rule is easy. Let’s take a look at an example. Let’s say your household brings in a total of $5,000 every month in gross income. Multiply your monthly gross income by .28 to get a rough estimate of how much you can afford to spend a month on your mortgage. In this example, you shouldn’t spend more than $1,400 on your monthly mortgage payment if you’re following the 28% rule.
Lenders don’t only look at your gross income when they decide how much you can afford to take out in a loan. Your debt-to-income ratio also plays a major role.
Your DTI ratio is a percentage that tells lenders how much of your monthly income goes toward debt and recurring expenses. Lenders use your DTI ratio when they calculate how much you can afford to pay on your mortgage every month. A higher DTI ratio means that you’re a riskier candidate for a mortgage because you have less disposable income. This means it’s more likely that you might miss a mortgage payment if you lose your job or run into financial hardship.
So how do you calculate your DTI ratio? First, add up your fixed monthly expenses. Only minimum payments and fixed recurring expenses count toward your DTI ratio. For example, if you have $15,000 worth of student loans but you only need to pay $200 a month, you’d include $200 in your debt calculation. Don’t include variable expenses (like utilities and transportation costs) into your calculation.
After you add up all of your debts, divide your monthly debt obligation by your gross monthly income. Then, multiply the result by 100 to get your DTI ratio. If your DTI ratio is more than 40%, you might have trouble finding a mortgage loan. To learn more about calculating your DTI ratio, read our complete guide.
Your DTI ratio and income are only two factors that your lender considers when they calculate what type of monthly payment you can afford. If you have a higher credit score or a larger down payment, you may still qualify for a loan with more debt or a lower income. The options available to you will depend on your mortgage lender’s standards.
Remember that the 28% “rule” is only a suggestion to keep your monthly payment affordable. The specific percentage of income that you’ll spend on your mortgage depends on your unique household budget and how much debt you have. However, the 28% suggestion is a great jumping-off point when you start to shop for a home loan.
What If I Can’t Afford For My Mortgage Payment To Be 28% Of My Income?
If you have more debt, you might struggle to keep your DTI low while also paying off a mortgage. In this case, it can be useful to work backward before you decide on a percentage of income for a mortgage payment.
Multiply your monthly gross income by .40 to determine how much money you can spend each month to keep your DTI ratio at 40%. Then, subtract all of your recurring, fixed monthly debt obligations. The dollar amount you have left after subtracting all of your debts lets you know how much you can afford to spend each month on your mortgage.
Let’s take a look at an example. Imagine that your household brings in $5,000 in gross monthly income. Your recurring debts are as follows:
- Rent: $500
- Minimum student loan payment: $250
- Minimum credit card payment: $200
- Minimum auto loan payment: $200
- Homeowners association fees: $100
In this example, your total monthly debt obligation is $1,250. Forty percent of your gross income is $2,000, and your recurring debts take up 25% of your gross income. This means that if you want to keep your DTI ratio at 40%, you should spend no more than 15% ($750) of your gross income on your monthly payment. Use a mortgage calculator and your estimated monthly payment to calculate how much money you can borrow and stay on budget.
Other Percentage Rules And Models
The 28% rule isn’t universal. Some experts recommend other percentage models. Let’s take a look at two of the most common alternatives to the 28% model.
The traditional 35%/45% model says that you shouldn’t spend more than 35% of your pretax income or 45% of your after-tax income on your mortgage payment. For example, let’s say your household income is $5,000 before taxes and $4,000 after you deduct taxes. In this example, you should put your upper limit for monthly payments between $1,750 – $1,800 per month.
The 35%/45% model gives you more money to work with when you calculate how much you can afford to spend each month on your loan. A higher monthly budget means you can buy a larger, more expensive property. It also means you can take a shorter loan and own your home sooner. This model can be particularly useful in areas with high local and state tax rates.
25% Post-Tax Model
The more conservative 25% model says you should spend no more than 25% of your post-tax income on your monthly mortgage payment. For example, if you earn $4,000 after tax deductions, you’d spend a maximum of $1,000 a month on your mortgage.
The 25% model might be right for you if you have other forms of debt. When you spend less on your monthly housing payment, you have more money to reduce student, auto or other types of loans. The obvious downside of this model is that it gives you less money to spend on your home.
The Percentage We Recommend
At Quicken Loans®, the income-to-mortgage ratio we recommend is 28% of your pretax income. This percentage strikes a good balance between buying the home you want and keeping money in your budget for emergencies and other expenses. However, it’s important to remember that you don’t need to spend up to your monthly limit. Think of 28% as the maximum amount you should spend monthly on your total mortgage payment. Remember to include your principal, interest, taxes and insurance in your total before you sign on a loan.
How To Get A Lower Monthly Payment
If you’ve got more debt, you might need to take on a lower monthly payment to keep your DTI ratio at 40%. Thankfully, there are a few strategies you can use to lower your monthly payment.
- Improve your credit score. One of the first factors that lenders consider when they decide how much you’ll pay in interest is your credit score. The higher your score, the lower interest rates you’ll qualify for. Take some time to focus on paying down debt and improving your credit score to qualify for the best rates.
- Take a longer mortgage term. The longer your mortgage term, the lower your monthly payment. If you take a longer term, you spread your payments over a larger number of months, which reduces the amount you owe each month. While taking a longer term will increase the amount you pay in interest over time, it can free up more cash to keep your DTI low.
- Save a 20% down payment.You don’t need to pay for private mortgage insurance when you put 20% down on your loan. PMI can add quite a bit of money to your monthly payment, so avoiding it can significantly reduce what you pay each month. You may also be able to avoid PMI with certain types of government-backed loans.
What’s Next: How Much Home Can You Afford?
So, what percentage of your income should go toward your mortgage? The answer will vary depending on your income and how much debt you have. But your income is only one of the many factors that determine how much home you can afford. Lenders look at everything from your credit score to your liquid assets when they decide how much to offer you. To learn more about how much of a mortgage loan you can afford to borrow, check out our home affordability calculator.