What Percentage of Income Can You Afford for Mortgage Payments?
This question often comes up among first-time home buyers: What percentage of my monthly income can I afford to spend on my mortgage payment? Does that percentage include property taxes? Private mortgage insurance (PMI) or homeowners insurance?
Most agree that your housing budget should encompass not only your mortgage payment (or rent, for that matter), but also property-taxes and all housing-related insurance (including PMI). As for just how big a percentage of your income that housing budget should be? It all depends on whom you ask.
In an article on new rules for first-time home buyers , the New York Times reported:
If you’re determined to be truly conservative, don’t spend more than about 35 percent of your pretax income on mortgage, property tax and home insurance payments. Bank of America, which adheres to the guidelines that Fannie Mae and Freddie Mac set, will let your total debt (including student and other loans) hit 45 percent of your pretax income, but no more.
Let’s remember, that even in today’s post-mortgage crisis world, mortgage lenders want to approve creditworthy borrowers for the largest mortgage possible. I wouldn’t call 35 percent of your pretax income on mortgage, property tax, and home insurance payments “conservative”. I’d call it average.
On the flip side, debt-hating Dave Ramsey wants your housing payment (including property taxes and insurance) to be no more than 25 percent of your take-home income.
Your mortgage payment should not be more than 25% of your take-home pay and you should get a 15-year or less fixed-rate mortgage…Now, you can probably qualify for a much larger loan than what 25% of your take-home pay would give you. But it’s really not wise to spend more on a house because then you will be what I call “house poor.” Too much of your income would be going out in payments, and it will put a strain on the rest of your budget so you wouldn’t be saving and paying cash for furniture, cars and education.
Notice that Ramsey says 25 percent of your take-home income while lenders are saying 35 percent of your pretax income. That’s a huge difference! Ramsey also recommends 15-year mortgages in a world most buyers take 30-year mortgages.
Not everybody is as debt-adverse as Ramsey, but I think you have to acknowledge he has a point: The more you spend on your home, the less you have available to save for everything else. You may be able to afford a housing payment that is 35 percent of your pretax income today, but what about when you have kids, buy a new car, or lose your job?
When you obtain mortgage pre-approval, lenders will likely approve you for a loan that would require housing payments closer to 30 or 35 percent of your pretax income. Don’t just assume “if the bank approved it; I can afford it”. That’s rarely the case.
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- FHA Mortgage Loans: A Good Idea for First-Time Buyers?
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I’m gonna stir the pot here a bit: If you’re conservative and shoot for 25% of your income for mortgage payments and you live in or near a major, expensive metropolitan area, you’re never going to buy anything. And waiting for forever may be more damaging in other ways down the road, especially when real estate prices are going to be somewhat depressed for the next couple years.
There’s some risk involved in almost any financial decision and there’s obviously risk involved in home ownership. But similarly, sitting on the sidelines for forever because you need to wait until you’re making two hundred grand to be able to afford a starter condo just isn’t realistic. In and around cities like San Francisco, Boston, or New York, you pretty much need to stretch to the very top of your range to afford much of anything unless you make well, well into six figures.
Touché, Jason. The market you’re trying to buy into will dictate how much you have to spend, and I wouldn’t tell somebody to postpone buying forever to wait until they can meet such a stringent budget.
I can, however, imagine Dave Ramsey’s rebuttal: “Then move somewhere else!” Obviously that’s not the answer.
His recommendation of 25 percent of take-home income is extremely conservative and, for most, probably the floor of what they would consider spending. My hope was simply to point out that going from his advice to lenders’ criteria—35 percent of gross income—is a big, big leap!!
I have a mortgage payment that is 22% of my pre-tax income including all taxes and insurance and I’m comfortable with that. I live in a respectable house in a good neighborhood. 35% seems high to me if you have a car payment and student loans especially. Also, I could barely rent in my area with 25% of my take-home pay like Ramsey says. I think a better guideline would be 25% of pre-tax income not 35%.
Dave Ramsey’s system potentially can make some people worse off in the long run.
For example, if someone who “shouldn’t” buy a home (according to Dave’s Rules) never buys a home, in the long run they could be worse off due to (1) never building any home equity, and (2) paying ever-rising rents, thus hindering their ability to save and invest.
Dave says that renting often makes sense in the short term, but isn’t a good long-term housing strategy. But Dave’s Rules set up many people to fail financially in the long run.
There is a huge difference between the two methods. Assuming you don’t include insurance and taxes in the 35% of pre-tax scenario, if you make $100,000/yr married, you’re looking at a $486,000 home. For 25% of post-tax at $100,000/yr married including insurance and taxes (0.5% and 0.75% annual based on home price, respectively), you’re looking at a $182,000 home. THAT IS A HUGE DIFFERENCE. A $300,000 difference! Note that all these calculations were done based on 6% interest and don’t include down payment information.
Personally, I’d like to stick to Dave’s rule. I know there are some markets where this may not be possible, but in the midwest, even with a $20k/yr job, you could get a house for this much. Yes it would be a very small house probably not in your first choice neighborhood. Yes, you’d have to shop around a lot to find it. But yes, it is doable. I don’t buy the “It’s not possible” line. We don’t NEED huge houses with 1+ rooms per person. What we NEED is a place that will protect us from the elements where we can lay our heads, cook food, and stay healthy (hygiene). There are many MANY cultures around the world that do just fine with much less than what Dave talks about. I’m not saying we should turn into a third-world country, but I certainly think we as Americans have gotten way out of control in what we spend on shelter… as if a larger house will somehow make us happier and get rid of our problems.
My wife and I are looking into what will be our second time buying a home. We sold our first home almost 2 years ago in 2008 because we relocated for my career. We didn’t make any money on the home sale but we didn’t lose any money either, so all-in-all I call that a huge positive for us. We’ve been sitting on cash for 2 years with absolutely zero debt.
Now however, we are looking to purchasing again and the dilemma I’m finding is that we could spend about 34% (income before tax) which would include PMI, Ins, HOA … every but basic utilities -Which we’d pay no matter where we live- on an excellent home on a nice golf course, pool, city view, etc.
-Or- we could pay significantly less than the 34% (as explained above) on more of a very basic home. I’m concerned that a very basic home (getting us closer to 25% or less) would be much more difficult to sell in future years because it seems so much less desirable. Granted it would be much cheaper and probably free up a lot of cash flow.
It just seems like the 34% home is a real gem whereas the basic homes would be much more inexpensive but … well it just seems as though the house with the pool on the course is tremendously marketable whereas any of the basic homes would look like just another home on the market if I want to sell in a few years.
Any thoughts?