What percentage of your monthly income should go to mortgage?

A general rule of thumb for homebuyers is your home loan should eat up no more than 28% of your pre-tax monthly income.

But some borrowers should set their personal level higher or lower. Below, we’ll help you figure out how much you can afford and we’ll also tell you the affordability rules lenders require for different types of mortgages.

How much house can I afford?

Generally speaking, your mortgage should be between 2 and 2.5 times your gross annual income. Add that number to your planned down payment and you’ll know the price range in which you should be house hunting.

But this, like most rules of thumb, has plenty of exceptions. Here’s why.

Salary is a poor indicator of mortgage affordability

Let’s suppose your salary is $100,000 a year. You could, by this rule of thumb, afford a mortgage of between $200,000 and $250,000.

But one person on that income may have much less left at the end of each month than another.

For example, let’s assume that one is a real estate agent with a big auto loan and credit card balance from expensive lifestyle choices. There’s nothing wrong with any of that — if he can afford it.

But another person with the same household income may have a much lower cost of living. Maybe he’s a freelance graphic designer who drives a paid-off car. His wardrobe costs a few hundred a year to maintain and he zeroes his card balances every month.

These two people have significantly different available income to pay towards a mortgage. So pre-tax income on its own doesn’t capture the whole picture.

Debt-to-income (DTI ratio is a better guide

Our two examples have precisely the same income but they have vastly different monthly budgets and thus different abilities to pay down a mortgage.

As a result, lenders are far more interested in an applicant’s debt-to-income ratio (DTI) than his or her raw income. It better reflects someone’s “discretionary income,” which is what’s leftover each month after unavoidable outgoings (including debt payments) are paid.

We’ll be getting into DTIs further on in this article — including how you can calculate yours.

Mortgage payments aren’t your only homeownership cost

There’s more to homeownership cost than your monthly payment. More on that later. But what makes up your monthly payment itself?

Mortgage professionals use the acronym “PITI” to cover some of the main ones. That stands for:

• Principal: The amount by which you reduce the amount you borrowed each month.
• Interest: The cost of borrowing.
• Taxes: The property taxes you have to pay.
• Insurance: Homeowners insurance. Plus, depending on where you buy, possibly flood, earthquake or hurricane cover.

None of these is optional and if you fall far behind on any of them, you’ll be in breach of your mortgage agreement and subject to action by your lender.

Other homeownership costs

If you choose to live in an area covered by a homeowners’ association, you’ll have to pay HOA dues.

And, absent warranties, every homeowner is responsible for the costs of maintenance and repair. The days when you could call your landlord when your HVAC failed or your roof sprang a leak are behind you.

Bear in mind that the older the home you buy, the higher your maintenance and repair costs are likely to be. And be sure to choose any home warranty you decide to buy carefully. There are sharks in these waters.

Understanding debt-to-income ratios

Debt-to-income ratios may sound complicated but they’re really not.

DTI calculations are only interested in unavoidable monthly debt obligations. That means they don’t take account of things on which you could economize, such as food, gas, utilities, insurance premiums besides homeowners insurance, phone, cable or other entertainment.

Front-end DTI and back-end DTI

There are two types of DTI: front-end and back-end. Front-end DTI looks only at your housing costs, meaning the PITI you’ll pay on your new loan.

You divide your expected monthly PITI by your gross monthly income and will get a number on your calculator. Let’s say 0.21, which would mean your front-end PITI is 21%.

Back-end DTI involves the same simple calculation but it’s based on all your unavoidable monthly payments plus PITI. So it’s almost always much higher. And the next few sections are going to walk you through the world of back-end DTIs.

Payment obligations

Back-end DTIs are based on inescapable outgoings:

1. Debt payments: All, including those for student, auto, and personal loans, timeshare agreements and any loans that you’ve co-signed.
2. Minimum payments on plastic: Credit and store cards.
3. Alimony and child support payments that have at least six months to run.
4. PITI (see above): Payments on your new mortgage.

Dig out recent bank statements so that you can use exact, accurate figures. Because every mortgage lender to which you apply is going to do just that.

Income

Mortgage lenders are typically pretty generous over what they count as income. So you can usually include:

1. Salary and wages
2. Tips and bonuses (with 2 years’ history)
3. Pension income
4. Social Security income
5. Child support and alimony that you receive
6. Dividends, rents and other investment income

Again, try to be as accurate as you can, using bank statements or other records going back a year or two. Average out irregular incomes so you know what you receive each month over a period.

And remember: we’re looking at gross income. So it’s the amount you receive before you pay tax.

The big calculation

The big calculation is actually a small one. Yes, you’ll find DTI calculators online but the math is so simple you probably won’t bother to use one.

If you’ve already done the hard work in finding and adding up your actual figures, all you need do is divide your total monthly debt by your gross monthly income.

Here’s an example, based on that mythical person with exactly $100,000 a year coming in, which means a monthly income of $8,333 ($100,000/12). We’ll give him $1,000 of existing monthly payments, and another $2,000 in PITI on his new mortgage. So his total payments will be $3,000.

Divide $3,000 by $8,333 and you’ll get 0.36%. Which means his DTI is 36%.

So now you know how to calculate your DTI, replacing our mythical friend’s figures with your own. And it’s that simple.

Other DTI models

That’s the main way of calculating DTI. But there are two other models that can be used:

1. 35%/45% model: Your total monthly inescapable obligations, including PITI, should be 35% or less of your pre-tax (gross) income. Or 45% or less of your after-tax (net) income.
   
2. 25% after-tax model: Multiply your net income by 25%. The answer tells you how much you can afford in monthly PITI payments.

All these models are interesting ways to see the size of the mortgage you might get approved for and what home price you can afford.

But mortgages aren’t one-size-fits-all products. If you have a lavish lifestyle or unusually high outgoings, you might not be able to afford the same monthly mortgage payment as someone else with the same income and inescapable monthly commitments.

So, what percentage of your income should go to mortgage? It’s the percentage you can comfortably afford. And you need to decide for yourself how much that is. Lenders’ rules are a good guide to affordability. But they may not protect you if your circumstances are unusual.

Some common DTI thresholds

Most lenders look for a maximum DTI of 40% on applications for most sorts of mortgages. But that’s a very general guideline. Some applicants get approved with DTIs or 45% — or, occasionally, even 50%.

But those approved with big DTIs are almost always strong borrowers in other respects. Perhaps they have a high credit score, a big down payment or such a high income that they can still afford to live comfortably even after they’ve paid all their inescapable monthly obligations.

How credit score and down-payment size impacts affordability

Every lender’s priority is to maximize its chances of getting its money back with as little expense as possible. They want to be as sure as they can that borrowers are ready, able and willing to make timely monthly payments.

Luckily, this protects most borrowers from taking on mortgages that they can’t afford or are incapable of maintaining.

Credit score

Having a high credit score suggests you’re good at managing your money. You’ve borrowed in the past and have paid back your loans with little or no bother so the lender can trust you to honor your financial obligations. And there’s a pretty reliable rule: The higher your credit score, the lower your mortgage rate.

It’s possible to be approved with a credit score as low as 580 for an FHA loan (backed by the Federal Housing Administration) with a 3.5% down payment. Indeed, for an FHA loan, your credit score can be as low as 500, providing you make a 10% down payment.

But many other types of mortgages require a minimum score of 620. And many lenders impose their own minimums, often 640 or 660. Of course, if you want a jumbo loan (an outsized mortgage that might involve millions of dollars), you’ll likely need a very high score.

Down payments

Just like a high credit score, a big down payment will nearly always buy you a lower mortgage rate. And, as we just saw with FHA loans, it can get lenders to be more flexible over other lending thresholds.

That’s because people with larger down payments are more financially invested in their home and stand to lose more money in the event of a foreclosure.

And, if things go horribly wrong and foreclosure becomes necessary, the lender stands a better chance of getting all its money back. As a result, the mortgage industry likes large down payments and rewards borrowers who have them.

Finally, borrowers who have down payments of less than 20% typically have to pay mortgage insurance premiums (MIPs) on federally backed loans and private mortgage insurance (PMI) on conventional loans. Borrowers who can come up with 20% of the sale price won’t have to.

Tips for lowering your monthly payment

There’s plenty you can do in the months leading up to a mortgage application to drive down your mortgage rate — and thus your monthly payments:

1. Reduce your borrowing. You’ve seen how important your DTI is so try to lower your debt burden. Focus first on getting all your credit and store card balances below 30% of their available credit limits.
   
2. Improve your credit score. Just getting those card balances below that magic 30% should raise your score very quickly. Don’t open or close any credit accounts in the run-up to a new application. Most importantly, continue to make every payment on time. And order a free copy of your credit report from annualcreditreport.com to check for mistakes, which are surprisingly common.
   
3. Start saving for the long term. Once you’ve reduced your debt, get saving. You may not have time to get together a substantial down payment this time around. But lenders will be impressed by any assets you have and making a bigger down payment than the minimum could buy you a lower mortgage rate. Meanwhile, saving should get you to the time when you can afford 20% sooner.

Start off with baby steps. You may not get to be a lender’s ideal borrower overnight but most of us can make ourselves a better bet quite quickly.