Mortgage Portioning: How Much House Can You Afford?

When buying a home, it's essential to consider your monthly expenses and overall cost. One of the most significant expenses you'll pay each month after purchasing a home is a mortgage. Lenders assess your mortgage qualifications based on several factors, including your income, debt-to-income (DTI) ratio, and credit score. The DTI ratio compares your monthly debt payments to your gross monthly income, and a higher DTI may make it challenging to qualify for a mortgage. To determine how much of your income should go towards your mortgage, there are several rules and formulas you can use to calculate your mortgage-to-income ratio.

Mortgage-to-income ratio

The mortgage-to-income ratio, also known as the front-end ratio, is the percentage of your yearly gross income that can be dedicated to paying your mortgage each month. This ratio is calculated by dividing the expected monthly mortgage payment by the borrower's gross monthly income. Gross income is the total amount of money earned before taxes and other deductions. Lenders consider gross income when evaluating a borrower's ability to make monthly mortgage payments. A higher gross income generally indicates that one can afford a more expensive home.

There are several rules and formulas to calculate the mortgage-to-income ratio. The most popular is the 28% rule, which states that no more than 28% of your gross monthly income should be spent on housing costs. This rule is popular because it strikes a good balance between buying the home they want and having enough money in the budget for emergencies and other expenses. The 28% rule is also part of the 28/36 rule, which states that no more than 36% of your gross monthly income should be spent on total debt costs, including student loans, car loans, or credit card payments.

Another rule is the 25% post-tax model, which suggests keeping your total monthly debt at or below 25% of your post-tax income. This model is considered more conservative and may be a better approach when dealing with other forms of debt. The 35%/45% rule may also provide more latitude when calculating how much you can afford to spend each month on your mortgage, but it doesn't factor in additional debts.

Ultimately, the ideal mortgage-to-income ratio will depend on an individual's financial situation. It is important to consider current debts, financial goals, total savings, expected income changes, and current living expenses.

Front-end and back-end ratios

When deciding how much of your income should go towards your mortgage, you can use several methods to determine the appropriate portion. One of the most significant challenges first-time buyers face is calculating the percentage of income that should go toward their monthly mortgage payment.

The front-end ratio, also known as the mortgage-to-income or housing ratio, indicates the percentage of your income that would go toward housing expenses if you were approved for your mortgage. It includes your monthly mortgage payment (principal and interest) and any payments toward property taxes, homeowners insurance premiums, mortgage insurance, and homeowners association fees. Lenders prefer the front-end ratio to be no more than 28% for most loans and no more than 31% for Federal Housing Administration (FHA) loans.

The back-end ratio, also known as the debt-to-income (DTI) ratio, indicates the percentage of your income that goes toward paying your debts. It includes all your monthly debt payments, such as credit card payments, auto loans, student loans, and child support. Lenders prefer a back-end ratio of no more than 36% because a higher ratio indicates an increased risk of default. However, some lenders may accept a higher ratio of up to 50% for borrowers with good credit or other mitigating factors, such as substantial down payments or sizable savings.

To calculate your front-end ratio, add up your monthly housing expenses, divide that by your gross monthly income, and then multiply the result by 100. For example, if your monthly housing expenses are $1,200 and your monthly income is $5,000, your front-end ratio would be 24% ($1,200 / $5,000 = 0.24, or 24%).

To calculate your back-end ratio, add up all your monthly debt payments, divide that by your gross monthly income, and then multiply by 100. For example, if your total monthly debt payments are $2,000 and your monthly income is $5,000, your back-end ratio would be 40% ($2,000 / $5,000 = 0.4, or 40%).

It is important to note that while these ratios are essential for mortgage approval, they are not the only factors considered by lenders. Other factors, such as credit score, down payment amount, and savings, can also impact a lender's decision. Additionally, these ratios do not include living expenses such as utilities, groceries, and other non-debt-related costs.

Down payments

The down payment is the cash you pay upfront to make a large purchase, such as a home. The size of your down payment will depend on your loan type, financial situation, and home-buying goals.

The amount of down payment you need to make varies according to the type of mortgage, the lender, and your finances. A 20% down payment is the most often-recommended amount for most loans and lenders. This is because, with a 20% down payment, you can avoid paying private mortgage insurance (PMI) on a conventional mortgage loan. PMI is insurance that protects the lender if a borrower defaults on their home loan. However, you don't need to make a 20% down payment to buy a house. There are some conventional mortgages that require as little as 3% down, provided you meet certain income limits. FHA loans, which are backed by the Federal Housing Administration, require as little as 3.5% down if you have a credit score of at least 580. If your credit score is between 500 and 579, you will need a 10% down payment. Jumbo loans, a type of conventional mortgage for high-priced properties, typically require 10% down or more.

It is important to note that a larger down payment can get you a lower interest rate. The median down payment on a home among all homebuyers was 18% in 2024, according to the National Association of Realtors, while first-time homebuyers put down a median of 9%.

While it is good to aim for a higher down payment to avoid additional costs like mortgage insurance, it is also important to consider your financial situation. Putting down too much could leave you strapped for cash after you move in. It is also important to consider the opportunity cost of waiting until you reach the 20% down payment threshold. Delaying may result in significant costs due to rising home prices and rents.

Monthly expenses

When considering taking on a mortgage, it is important to understand the components that make up a mortgage payment. Each month, a portion of your payment will go towards PITI – principal, interest, property taxes, and homeowners insurance. If your down payment is less than 20%, you will also have to pay mortgage insurance.

In addition to the mortgage payment, homeownership involves other costs like maintenance, property taxes, and insurance that you will need to take into consideration. Many online resources are available to assist in calculating mortgage affordability. It is recommended to set aside 1% to 4% of your home's value each year to create a fund for maintenance.

Your monthly expenses, income, and down payment are generally the base qualifiers for financing, while your credit history and score determine the interest rate on the financing. This is the level of income a prospective homebuyer makes before taking out taxes and other obligations. This includes your base salary, bonus income, part-time earnings, self-employment earnings, Social Security benefits, disability, alimony, and child support.

Lenders will also want to confirm that your income is enough to cover all debts, including your new home loan, and living expenses. This is done by calculating a debt-to-income ratio (DTI). According to the FDIC, most lenders look for a maximum DTI in the 33-36% range of your net income. Lenders will also look at your credit score to determine how reliably you have used credit in the past.

There are several rules and formulas to help you calculate your mortgage-to-income ratio and determine how much home you can afford. The most popular is the 28% rule, which states that no more than 28% of your gross monthly income should be spent on housing costs. The 25% model may be a better approach when dealing with other forms of debt, as it allows you to spend less on your monthly housing payment and have more money to pay your bills.

Lender affordability estimates

• Gross Income: Lenders primarily consider your gross income, which is the total amount earned before any taxes and deductions. A higher gross income generally indicates that you can afford a more expensive home. This is because a larger proportion of your income can be dedicated to mortgage payments. The general guideline is that you can afford a property whose mortgage is between two and three times your annual gross income.
• Debt-to-Income (DTI) Ratio: Your DTI ratio is a critical factor in a lender's assessment. It compares your monthly debt payments, including the potential mortgage, to your gross monthly income. Lenders use this ratio to understand how much of your income is available for a mortgage payment after meeting your existing debt obligations. A higher DTI may make it more challenging to qualify for a mortgage as it indicates less disposable income. The recommended maximum DTI ratio varies, with sources suggesting a range between 36% and 45%.
• Credit Score: Your credit score also plays a role in a lender's evaluation. A higher credit score can qualify you for lower interest rates, making it easier to secure a mortgage. Conversely, a lower credit score may result in higher interest rates, impacting your overall affordability.
• Down Payment: While not directly influencing the lender's affordability estimates, the size of your down payment is crucial. A larger down payment of 20% or more can help you avoid paying for private mortgage insurance (PMI), resulting in lower monthly payments. A smaller down payment, typically ranging from 5% to 10%, is common for first-time homebuyers but leads to higher monthly payments and the inclusion of PMI.
• Rules of Thumb: Various rules of thumb can guide you in determining how much of your income should go towards your mortgage. The most commonly referenced rule is the 28% rule, suggesting that your mortgage payment, including principal, interest, taxes, and insurance, should not exceed 28% of your gross monthly income. This rule strikes a balance between purchasing a desirable home and maintaining budget flexibility for emergencies and other expenses.
• Other Considerations: It's important to remember that these estimates and rules are general guidelines. Your personal financial situation, goals, and consumption choices will influence how much you can afford. Additionally, consider the ongoing costs of homeownership, such as maintenance, repairs, and increased utility expenses, which can impact your overall affordability.

Understanding lender affordability estimates involves assessing your financial situation, including income, debt, and creditworthiness. These factors collectively contribute to a lender's evaluation of your ability to secure and sustainably manage a mortgage.

Frequently asked questions