How to Determine the Percentage of Income for Mortgage
March 15, 2021
8 MINUTE READ
How to Determine the Percentage of Income for Mortgage
When you purchase a home, it’s vital to know what percentage of your income will be saved for your mortgage . Housing ratios and ‘debt-to-income’ ratios are ways of calculating the percentage of gross income for mortgage payments and who qualifies for mortgage loans. Debt to income ratios work using the 28/36 rule , which we’ll explain in detail later in this post.
What is the housing ratio? Simply put, the housing expense ratio is a ratio that compares your pre-tax income to housing expenses on the real-estate market. Lenders use this calculation when they decide who will qualify to borrow for a loan.
Understanding what percentage of your monthly income should go to your mortgage payments can help you budget and live comfortably. Nobody wants to be ‘house poor,’ struggling to make ends meet in order to make mortgage payments.
If you’re wondering ‘ what is another term for housing ratio ?’ It’s sometimes referred to as the front-end ratio as it is a partial component of a borrower’s total debt-to-income. Therefore, it should be considered early in the underwriting process for a mortgage loan.
Don’t worry, we’ll be explaining front-end ratios, back end ratios, gross income, net income, and mortgage percentage payments as you read on. We will follow this up with some essential guidelines for obtaining an affordable mortgage.
But first, let’s answer a fundamental question:
What Percentage of Your Income Should Your Mortgage Be?
Calculating the percentage of income for your mortgage payments will help you understand exactly how much you can afford to spend. Buying real estate via a mortgage is the largest personal investment that most people make in their lifetime.
For this reason, working out how much you can comfortably borrow depends on several factors. It’s not just a question of how much the bank is willing to lend you. Factors such as the mortgage percent of your net income , finances, priorities, and preferences are all part of the equation.
As a general rule, most prospective homeowners can finance a property that costs anywhere between two and two-and-a-half times their gross annual income (pre-tax earnings). Now, let’s imagine that you earn $100,000 per year. This would mean that you can afford a mortgage between $200,000 and $250,000. However, this calculation is only a general guideline.
Ultimately, when you consider buying a property, there are several essential factors to consider. Primarily, you need to have a good idea of the amount your lender thinks you can afford (and how they calculated this figure). Next, it helps to take a personal inventory and think about the type of home where you would like to live. If you plan to live in your new home for many years, what sort of things will you be willing to trade-off—or not—to afford your dream home?
Understanding Gross Income, Net income, and Mortgages
Before you can calculate the income percentage for your mortgage, you’ll need to understand what defines ‘gross income’, ‘net income,’ and ‘mortgages.’
As such, let’s break these definitions—one-by-one.
Gross income for individuals (also called gross pay when printed on a paycheck) is the total payment you receive from your employer before any taxes or other deductions. Gross income is not limited to cash payments; it includes services received and property. Your gross annual income is the amount of money you earn in a year before tax and includes all your income sources.
For businesses, gross income is identical to gross margin or gross profit. As printed on their income statement, a company’s gross income is the revenue earned from all sources minus the cost or services or cost of goods sold (COGS).
Net income is the total amount earned by a person in any given period from their taxable wages, investment incomes, tips, and any other income. The amount is calculated after Social Security taxes, income taxes, Federal Insurance Contributions Act (FICA) tax, 401k payments, health insurance, and any outstanding legal obligations such as child support, loan payments, and wage garnishments.
For individuals, net income is calculated using this equation:
Total amount Earned (Gross Income) – Paycheck Deductions = Net Income.
A mortgage is a loan, provided by a bank or mortgage lender, enabling an individual to purchase a property or home. Although it’s possible to receive loans that cover the entire cost of a property, it’s more common to secure loans for around 80% of a home’s value.
Mortgages are paid back over time, typically over 15 or 30-year terms. The property purchased acts as collateral for the money lent by an individual to buy the home.
Front-End Ratio and Back-End Ratio
When determining whether you’ll be able to pay back a mortgage, lenders look at two debt-income ratios; these are known as qualifying ratios.
The front-end ratio calculates the total expense of your house against your monthly income. The back-end ratio looks at recurring monthly expenses such as your credit card debt and student loans before providing a number that lenders use to evaluate your income and expenditure.
As part of your mortgage qualifying package, lenders will also examine your credit score. If your number falls outside of the lending limits, mortgage requests will be manually written so that they can be adjusted for compensating circumstances.
As a rule of thumb, For a standard conventional loan backed by Fannie Mae or Freddie Mac, you need a median FICO Score of at least 620 for fixed rate mortgages, whereas adjustable rate mortgages need a minimum of 640 to qualify.
Working out what percentage of income you can afford for your mortgage establishes your front-end ratio. If you earn $60,000 per year, you must divide this amount by 12 to find your monthly income. Now, calculate your monthly housing expense: Include interest, insurance, principal, taxes, and mortgage insurance. Divide this number by your monthly income to calculate your front-end (debt-to-income) ratio.
For example: let’s imagine that your housing expenses are $1,000 and you earn $5000 per month. 1000 divided by 5000 = a 20% front-end ratio. The majority of lenders use 28% as a benchmark percentage for the front-end (debt-to-income) ratio.
To calculate a back-end ratio, you must add up all of your monthly recurring expenses and then divide them by your monthly income. Regular expenses could include car loans, rent, credit card debts, child support, alimony, and student loans.
In addition, the monthly payment for a deferred student loan is calculated as either 1% of the outstanding loan balance or the full payment amount according to your loan documents. For example, if you have $35,000 in student loans outstanding, the monthly debt payment included in your debt-to-income ratio is $350 ($35,000 * 1% = $359)
For example: Let’s say you have $1,700 in recurring monthly expenses, including housing, divided by $5000. This would mean that your monthly income equals a 34% back-end debt to income ratio. This would satisfy lenders, as they favor ratios below 36%.
It is from these calculations that we get the 28/36 rule. You can use this free 28/36 rule calculator to work out your front and back end ratios.
Examples of Mortgage Payment Percentage
Now, let’s look at some examples of mortgage payment percentages so you can work out how much you can afford to borrow from a lender and what percentage of income you need for your mortgage.
What value of property can you afford on a $60,000 a year income?
As mentioned above, the rule of thumb is that you can typically afford a mortgage two to 2.5 times your yearly wage. That’s a mortgage between $120,000 and $150,000 at $60,000 per annum. However, you’ll have to be able to afford the monthly mortgage payments.
What are the payments on a $200,000 mortgage?
Let’s imagine a $200,000, 30-year mortgage with a 4% interest rate. This would set you back about $954 per month.
What are the monthly payments on a $300,000 mortgage?
With a 4% fixed interest rate, monthly mortgage payments on a 30-year mortgage would total around $1,432.25 a month. However, if you opt for a 15-year plan, it could cost up to $2,219.06 a month.
Guidelines for an Affordable Mortgage
Everybody wants an affordable mortgage that leaves them enough money each month to enjoy life to the fullest while paying off their home.
The following tips will help you acquire an affordable mortgage:
1. Keep Monthly Costs Below 42% of Your Income: Keep all credit cards, loans, home insurance costs, bank obligations, mortgage principal, and interest lower than 42% of your gross income.
2. Understand the Benefits of 5% Down Payments: If you have 5% to put down on a property, some lenders will give you mortgages with no closing costs. However, you must make sure you can truly afford this deposit. First-time homebuyers who can’t afford a large down payment but would otherwise qualify for a home loan may be eligible for a 3% down payment mortgage.
3. Plan Ahead for Future Maintenance: Consider monthly maintenance costs and factor these into your budget.
4. Don’t Be Greedy: Loan approvals aren’t always perfect for your circumstances. Weigh your financial situation before agreeing to something that you can’t afford.
5. Factor in all Expenses: Remember to work out moving expenses, home inspections, appraisal fees, utilities, furniture, and temporary storage.
Buying a new home is an exciting process. However, you must do the math and figure out what percentage of income will be saved for your mortgage while still living comfortably. Luckily, we can help. If you’re buying a new home, we can help get you pre-approved and funded for a super-fast loan.