Have you ever wondered how mortgage lenders determine how large of a mortgage you can qualify for? It all comes down to percentages. To answer the question “how much mortgage can I get?”, you’ll need to know what percentage of income should go to a mortgage.
How much of your income should go to a mortgage?
Lenders have several ways of calculating how much of your income should go toward your house payment, and they all involve percentages.
The 28/36 rule
This formula has been used by the mortgage industry for decades. It holds that not more than 28% of your stable monthly income should go toward your new monthly house payment. And not more than 36% of your stable monthly income should be dedicated to your new monthly house payment, plus other recurring monthly debts. (Your stable monthly income is your pre-tax income, not your net take-home pay.)
Your new house payment is defined as the combination of the principal and interest on the new mortgage, and monthly allocations for real estate taxes, homeowner’s insurance, private mortgage insurance, and homeowner’s association (HOA) dues, if any.
Other recurring monthly debts include payments for car loans, student loans, other installment debts, credit cards, and any court-ordered payments, like child support or alimony. Note that other expenses, like insurance payments and utilities are not included in your recurring debt for mortgage purposes.
28/36 works like this: Your stable monthly income is $10,000. Your new house payment is $2,500, including principal and interest, taxes and insurance. The housing debt ratio, therefore, is 25%, which is well within the 28% guideline.
If you also owe $1,000 per month toward a car payment, credit cards and other installment debts, your total obligations – including the new house payment – is $3,500. That puts the total debt ratio at 35%, which is within the 36% guideline.
The 25% post-tax method
This calculation can be a bit more restrictive than 28/36. It limits your new monthly house payment to not more than 25% of your after-tax income.
Continuing the same example from above, let’s say your $10,000 in stable monthly income falls to $8,000 per month after taxes. With a new monthly house payment of $2,500, your debt ratio would come in at a little over 31%. That being the case, the lender might decline your loan application for an excessive debt ratio.
Fortunately, the 25% post-tax method is not commonly used by mortgage lenders.
The 35/45 Method
This method uses something of a combination of 28/36 and 25% post tax. It holds that your total debt, including your new house payment, should not exceed 35% of your total (before tax) stable monthly income, or more than 45% of your monthly after-tax income.
Once again, carrying the first example forward, your total monthly debt – including your new monthly house payment – is $3,500. When divided by your stable monthly pretax income of $10,000, the debt ratio is 35%.
And when $3,500 is divided by your $8,000 after-tax monthly income, the ratio is 43.75%.
Just as is the case with the 28/36 method, you would qualify for the home purchase based on the 35/45 method.
How do Lenders Determine How Much Mortgage I Can Afford?
Whether the debt-to-income (DTI) ratio is 28/36, 25% post-tax, or 35/45, the calculation itself is just one guideline among many used by lenders. In fact, DTI ratios are frequently exceeded if borrowers are strong in those other factors.
Those other factors include the following:
Occupation
Certain occupations are well-known to offer predictable upward income mobility. Examples include doctors, lawyers and engineers. More leeway will be given to someone in this type of occupation, even if the debt ratios are exceeded.
Credit
Excellent credit, especially with credit scores above 750, give lenders plenty of leeway to exceed DTI guidelines. Conversely, a score below 680 may cause the lender to strictly enforce income guidelines.
Employment stability
Lenders look with favor on those who have been occupied in the same field for many years. This is especially true if the borrower has shown a pattern of progressively higher earnings and regular promotions.
Income stability
Lenders will typically be more generous with DTI ratios for an applicant who is salaried. More caution will be used for those who have variable incomes, like the self-employed, those who primarily earn commissions, or borrowers who work in occupations that involve a pattern of seasonal employment.
Loan-to-value (LTV) ratio
This is simply the new mortgage amount, divided by the value of the property. Though lenders will commonly lend up to 97% of the property value, DTI ratios will be strictly enforced at that level. However, on loans involving an LTV of 80% or less, debt ratios are commonly exceeded.
If a borrower or borrowers exceed two or more of the above factors, it’s not unusual for lenders to accept a total debt ratio of 43%. With several positive factors, the DTI may be permitted at greater than 50%.
Mortgage payment rules and methods
There are two other factors mortgage lenders use to determine the acceptability of DTI ratios, though they’re less commonly used than in the past.
The first is loan type. Mortgage lenders tend to be more lenient with fixed-rate loans. That’s because both the interest rate and the monthly payment will remain fixed for the entire term of the loan.
Adjustable-rate mortgages, or ARMs, can be a different story. The payment will remain fixed for only the first few years, after which the loan will convert to a one-year adjustable. Lenders are more likely to hold to numeric DTI guidelines, like 28/36 with ARMs.
The second factor is the change in the monthly house payment. Lenders look more favorably on a borrower whose new house payment will increase by no more than 10%.
For example, if your new house payment will be $2,200 per month, but you’ve been successfully managing a $2,000 per month payment for the past seven years, the lender will be more likely to approve your loan with a higher DTI.
As you can see, mortgage payment rules and methods are more art than science.
Additional Home Buying Costs to Consider
Have you noticed that in all the calculations we’ve done thus far we’ve only included basic monthly payments? Conspicuously absent are variable expenses, or “soft costs”, that are also common with homeownership.
This includes, first and foremost, repairs and maintenance. It includes everything from replacing a jammed door knob to fixing a leaky roof. None of that is included in your DTI ratios.
Nor is more routine maintenance, like lawn care, pest protection, the cost of home security, or as we mentioned earlier, utilities.
There are other even bigger costs that are inherent with homeownership. Think replacing the roof, repaving the driveway, or adding a new air conditioner or furnace. Each of those expenses individually will cost many thousands of dollars.
There will also be periodic renovations. Those could include repainting the entire home, replacing kitchen cabinets, or renovating bathrooms.
For qualification purposes, your lender won’t consider any of these expenses when you apply for a loan. But as the owner of the home, you’ll need to be prepared for each.
Plan to use a two-part strategy that will include:
- Set up a budget to accommodate all the variable expenses above. A dedicated savings account is an outstanding way to do this.
- Plan to purchase a home with a monthly payment that’s a little below what the lender will allow. Even if the lender will approve a housing debt ratio of 28%, think more in terms of 25%, or even 23%. That will give you the extra room in your budget to cover those other expenses.
Though it may be comforting when a lender pre-approves you for a mortgage amount of X, be sure you can easily handle whatever the payment will be. If not, consider purchasing a less expensive home.
Tips for Lowering Your Monthly Mortgage Payment
There are several strategies you can use the lower your monthly mortgage payment:
Improve your credit score
Your credit score will have a major impact on the interest rate and payment you’ll make on your mortgage. The website myFICO.com calculated the effect of your credit score on your house payment and rate based on a $200,000 mortgage for 30 years as follows:
| Fico Score | APR | Monthly payment | Total interest paid |
|---|---|---|---|
780-850 | 4.17% | $975 | $150,833 |
700-759 | 4.392% | $1,001 | $160,208 |
680-699 | 4.569% | $1,022 | $167,771 |
660-679 | 4.783% | $1,047 | $177,020 |
640-659 | 5.213% | $1,100 | $195,938 |
620-639 | 5.759% | $1,168 | $220,584 |
As you can see, raising your credit score by about 100 points can save you about $100 per month on a $200,000 loan. That’s $1,200 per year, or $36,000 over 30 years!
Make a larger down payment
The larger your down payment, the lower your mortgage balance and monthly payment will be. The biggest payoff can be from making a down payment of 20% or more.
On conventional loans, private mortgage insurance (PMI) is required anytime you make a down payment of less than 20%. At a down payment of % or less, the monthly payment on PMI alone can add hundreds of dollars to your total house payment.
By saving a 20% down payment or getting a gift from a family member to help, you can eliminate this major expense. And that will lower your monthly payment.
Take a 30-year loan
Many financial advisors recommend a 15-year mortgage. The logic is sound; you’ll pay off the loan in half the time and save a fortune in interest. But the monthly payment will also be higher, as in much higher. The payment on a 15-year mortgage could be 30% to 40% higher than on a 30-year loan.
The better strategy is to take a 30-year loan and make payments based on a 15-year payout. You’ll have an opportunity to pay off the loan early, but you can revert to the 30-year payment if your budget gets tight.