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?
Rule 1: Consider your total housing payment, not just the mortgage.
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 — homeowner’s insurance, as well as PMI. As for just how big a percentage of your income that housing budget should be? It all depends on whom you ask.
Income used for housing: What others say
The traditional model: 35 percent/45 percent of pretax income.
In this article on how the mortgage crash of the late 2000’s changed 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 the post-crisis lending 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.
The conservative mode: 25 percent of after-tax income!
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 percent 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 percent 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 where most buyers take 30-year mortgages. This is what I’d call conservative.
Our take: Somewhere in between
Not everybody is as debt-averse as Ramsey — and following his one-size-fits-all advice has risks. You just have to remember: 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?
Another reader put it this way:
- Your mortgage payment should be equal to one week’s paycheck.
- Your mortgage payment plus all other debt should be no greater than two weeks’ paycheck.
That’s on the conservative side, too. One week’s paycheck is about 23 percent of your monthly (after-tax) income.
If I had to set a rule, it would be this:
- Aim to keep your mortgage payment at or below 25 percent of your pretax monthly income.
- Aim to keep your total debt payments at or below 33 percent of your pretax monthly income.
As some commenters have pointed out, while it may be possible to buy a decent home in a small midwestern town for $100,000 (and well within these ratios), workers in New York or San Francisco will need to spend five times that amount just to get a hole in the wall. Yes, people tend to earn more in these high-cost-of-living areas, but not that much more. Does it mean they shouldn’t buy a home? Not necessarily. They’ll simply have to make trade-offs to buy in those areas.
Just remember that when you obtain mortgage pre-approval, lenders will likely approve you for a loan amount with payments of up to 30 or 35 percent of your pretax income. That may tempt you to take on more home than you should. Don’t just assume that just because the bank approved it, you can afford it. They are two very different things.
In the market for a house sometime soon? Use our resources to target your search — and know well in advance what you can afford:
- Home affordability calculator
- How much house can you afford?
- See how much home you can afford with a fast, no-obligation online pre-approval. Learn more here »
Editor’s note: This article was originally published in February 2013. It has been thoroughly updated for relevance and accuracy before republication.