Blog posted On November 12, 2020
Deciding how much money you want to spend on a house is a big decision. For many people, it’s the most expensive purchase you will make. To help you decide, you will likely want to get a letter of preapproval from a mortgage lender first – this will tell you the maximum amount of money you are qualified to borrow. However, it should not dictate the maximum amount of money you should borrow from your lender.
Although we can tell how much you are qualified to spend; it is up to you to determine how much you are comfortable spending. To help you decide, most financial experts recommend that you follow these two main rules when taking out a mortgage: the annual salary rule and the monthly income rule.
The annual salary rule
In general, your ideal home loan should not exceed three times your annual salary. For example, if you earn $80,000 per year, your mortgage should not exceed $240,000. If you are living with a partner who will be contributing to the mortgage, then you can use your combined incomes to set your mortgage limit; if you take home $80,000 and your partner takes home $50,000, then your maximum mortgage would be $390,000.
Exceptions to the annual salary rule might include areas that have a higher cost of living. Following the “three times your salary” rule might not be realistic for people living in areas with high cost of living, according to Certified Financial Planner (CFP) Mark Reyes, because you will need to spend more of your income on other expenses. If you are buying a home in a high-cost area, it’s important to establish financial security first, such as an having a solid emergency fund and retirement savings account.
The monthly income rule
Your monthly income is an important factor in your front-end debt-to-income (DTI) ratio or mortgage-to-income ratio. This ratio is the percentage of your income that you can put toward monthly mortgage payments, which should be no more than 28% of your gross monthly income. If you earn roughly $6,600 per month, then you should only be spending a maximum of roughly $1,800 a month on mortgage payments. Your mortgage payment will consist of four categories: principal, interest, taxes, and insurance. These categories are more commonly known as PITI.
Your monthly income also plays a role in your back-end DTI, or simply DTI. Your DTI calculates the percentage of your income that you pay toward debts, including credit cards, student loans, and other outstanding debts. A good debt-to-income ratio typically will stay below 36%, but the lower the better. With a monthly income of $6,600, you should strive to keep your monthly debt under $2,380. If you subtract $1,800 for your monthly mortgage payment, that leaves $580 for other borrowing expenses.
A common mortgage mistake is purchasing a home that you can’t afford. Just because you get preapproved for a certain amount of money does not meant that you have to spend the maximum amount. Financing with a mortgage that you can’t comfortably afford can be a difficult burden to bear because it is hard to change without selling your home and moving.
Determining how much you are comfortable spending on a mortgage can be tricky. Before you start touring homes, talk to us today about getting preapproved. Then you can gain a better idea of your price range and use the two mortgage budget rules to help find the perfect home with a price that’s right for you.