Home affordability is all over the news. How much home debt is too much?
Since the current economic crisis is due in part to mortgages that became unaffordable, it’s no wonder that many homebuyers are being more careful about the price tag on homes they buy and, ultimately, the mortgage loans they accept. Because a home purchase is such a long-term commitment, it’s important not to take on too much home debt. If your home is unaffordable, you risk having your home foreclosed.
Figuring out how much home debt is too much can be an involved process, but once you have a mortgage you can afford, and you’re continuing to meet your other financial obligations, you’ll be happy you did the due diligence.
Whether you’re taking on – or currently have – too much home debt depends on a few things.
How High Will the Mortgage Be
Generally, the higher your income, the higher mortgage you can afford. You can use a housing payment-to-income ratio to gauge whether a mortgage payment is too high.
Your monthly mortgage payment consists of four different components:
- Principal, the money that pays down your loan balance. The principal represents the selling price of the home minus your down payment.
- Interest, the cost paid to the lender for allowing you to borrow your mortgage loan.
- Taxes, property taxes paid on your home.
- Insurance, homeowners insurance paid on your home and private mortgage insurance (PMI) if you have less than 20% equity in your home.
These four components are commonly referred to as PITI (principle, interest, taxes, insurance). When we talk about your housing payment-to-income ratio, we mean the percentage of your monthly gross income that goes toward paying your PITI. For example, if your monthly income is $5,000 and your mortgage payments would be $1,500, your housing payment-to-income ratio would be 30%. Lenders refer to your housing payment-to-income ratio as a front-end ratio.
Generally, a ratio of 28% is conservative, while a ratio greater than 32% could be difficult to maintain. Lower housing payment-to-income ratios are presumably easier to manage, but it depends on your total financial picture.
Even though lenders have their own requirements for housing payment-to-income ratios, you should have an idea of the amount of income you feel comfortable paying toward your mortgage.
How Much Debt Do You Have
What you spend on other debt also has an impact on how much you can afford to spend on monthly mortgage payments. Your debt-to-income (DTI) ratio, called the back-end ratio by lenders, lets you know how what percentage of your income goes toward paying your current debts. The lower your DTI ratio, the better.
Lenders generally look for a DTI ratio that’s 36% or less, but some will approve a higher ratio if, you have a good credit score. However, having more of your income going toward debt will make it harder to afford your mortgage payment.
For example, if you have a DTI ratio of 36% and the mortgage you’re looking at will give you a housing payment-to-income ratio of 28%, you’d be spending 64% of your income on debt payments. That would only leave 36% of your income to spend on other expenses. Considering that these ratios are based on gross income, you’d have even less money since as much as one-third of your gross income could be going toward income taxes and benefits.
What About Your Other Financial Goals
You probably have other financial goals like saving for retirement or for your children’s college. As you’re looking at what a mortgage will do to your finances, think about the other things you need to spend money on during the month. If you’re spending as much as 64% of your income on mortgage and debt payments, you would have little left to cover your other living expenses. Saving for the future would be an afterthought. As you think about how much you’re paying on your mortgage, make sure you think about the other things you’d like to do with your money.
Using Online Home Affordability Calculators
There are a number of online mortgage calculators out there that can help you evaluate whether your home is affordable. Some are simple, like this one from CNN Money, and only evaluate your income, down payment, and PITI. Others, like this one from SmartMoney.com, let you enter much more information including maximum payment-to-income ratio and other debt payments.
One of my favorite home affordability calculators is from Quicken Loans. This calculator allows you to enter your income and expenses, then tells you the monthly mortgage payment you can afford based on the information you’ve entered.
Before you start shopping for a mortgage loan, look at your income, expenses, debt, and savings goals. Then, decide what you can comfortably afford to spend on a monthly mortgage payment. You can enter your desired monthly payment into this amortization calculator to get the mortgage amount you can afford. Leave the principal box blank, then click the “Calculate” button. The principal box will fill in with the principal amount you can afford based on that amount.
Lenders might try to convince you to accept a mortgage loan simply because your income and credit score qualifies you for it. But, only you truly understand your finances, so don’t be fooled into taking on more home debt than you can afford.