Buying a new home is an exciting time. Maybe you’re a first-time buyer who’s been dreaming for many years of homeownership, or perhaps you’re moving to a larger home to gain more space for your growing family.
But it’s important not to get carried away. A recent study by researchers at Harvard University found that a staggering 40 million Americans live in housing that they can’t afford.
A critical question to ask is what percentage of your income should you spend on housing? Read on to find out the answer to this question, and other critical issues surrounding borrowing for homeownership.
What Percentage of Your Income Should You Spend on Housing?
The traditional model, advocated by the Bank of America following the mortgage crash in the late 2000s, recommends spending no more than 35% of your pre-tax income on housing. This includes your mortgage, property tax, and home insurance payments.
This model also recommends that your total debt should be no more than 45% of your pre-tax income. That means the combination of your mortgage, student loans, and any other borrowing such as unsecured loans or credit cards.
A more conservative approach is adopted by finance guru Dave Ramsey, who advises that you should allocate no more than 25% of income for mortgage payments, property taxes, and insurance.
While it’s likely that most people could secure a mortgage loan with a much higher salary-to-mortgage ratio, the conservative view states that spending too much on housing has negative consequences. It’s unlikely you will be able to get cash flow for replacing cars, furniture, and other expensive items, or save for the future.
The 28% Rule
The 28% rule is the most often referenced in response to the question of what percentage of income should go to mortgage payments. It states that your mortgage payments should be no more than 28% of your gross household income.
Let’s look more closely at how to calculate this. Your gross income is your total household income before deductions, including debt payments, taxes, and other expenses. It’s your gross income that lenders are usually most interested in when it comes to deciding how much you can borrow for your mortgage.
If you multiply your gross income by 0.28, then you will have a rough estimate of what an affordable mortgage payment might be.
Salary-to-mortgage ratio is not the only factor to consider though. Your debt-to-income ratio is also important.
Mortgage lenders want to know what proportion of your monthly income goes to debt and other recurring expenses. Your debt-to-income ratio helps to determine what an affordable mortgage payment would be.
You can calculate this by adding up all your monthly debt repayment obligations and dividing it by your gross monthly income. If your debt-to-income ratio is higher than 40%, you might have trouble getting a mortgage.
Other Factors to Consider
One aspect of homeownership that first-time buyers often forget to consider is maintenance costs. If you’ve lived in rental properties for a long time, you can get used to just calling the landlord when there’s a problem.
But when you own your own home, even with a mortgage, the cost of all repairs is down to you. Some financial experts say you should budget 1% of the overall value of your house for planned and preventative maintenance.
There is a financial school of thought which says that you should include maintenance in your affordability calculations, along with your mortgage payment. You should also consider property taxes and insurance costs.
The Consequences of Borrowing Too Much
The most serious consequence of over-borrowing is that you could lose your house. If you’re not able to pay your mortgage, then you won’t be able to stay in your home. If your mortgage payment is a struggle to meet, you may fall behind in paying other debts too.
Even if you can keep up with your housing costs and other debts, stretching yourself too far with housing costs can have long-term consequences. You might have to give up the luxuries that make life enjoyable, like eating out and traveling. You may also struggle to save for the future, including retirement and your children’s education.
So it makes sense to follow the advice and ensure that your mortgage payment is comfortably within your means. This will reduce stress on a day-to-day basis and ensure that you can meet all your financial obligations.
How to Reduce Your Monthly Payment
There are a few things you can do to try and reduce your monthly payment, to make sure your mortgage is affordable. This is especially important if you have a lot of other debt, as you need to keep your DTI below 40%.
You can reduce your monthly payments by taking a longer mortgage term. This means spreading your payments out over a larger number of months. You will pay more interest in the long run, but it will keep your monthly payment lower.
If you have a lot of debt, you may need to focus on improving your credit score. A poor credit rating is a red flag to mortgage lenders. So you should concentrate on paying other debt down first, then you will qualify for better mortgage rates.
Finally, you should make sure you shop around for the best deals and get some expert mortgage advice. There are a lot of products on the market and things move quickly, so it’s a good idea to seek professional help.
Choosing a Mortgage
So what percentage of your income should you spend on housing? The answer will depend on various factors, including your existing levels of debt and other financial obligations. But you should be a lot better-informed now, having read this article.
If you’re ready to take the next step and choose a mortgage to buy your next home, don’t hesitate to make contact with us and get a quote now.