What can I afford in mortgage payments?

Reader question: “I am planning to buy a house later this year. Between my wife and I, we earn about $110,000 a year. What can I afford in mortgage payments, based on such an income? I’m not really sure how to set up a budget for such a thing, as this is my first time buying a home.”

Well, I can tell you that you’re not alone. This is actually one of the most common questions we receive from our readers. It seems a lot of people are wondering the same thing: What can I afford to spend on a mortgage loan? This is a question that only you can answer for yourself. I would never presume to tell you where your financial comfort-zone lies. I can, however, show you how to do the math to create a basic home-buying budget. So let’s jump right in…

It’s Your Responsibility, Not the Lender’s

The first thing you need to understand is that it’s your responsibility to determine what you can afford in a mortgage loan. It is not the lender’s responsibility. This may come as a surprise to you, as it does to many first-time home buyers.

Mortgage lenders can sell home loans into the secondary mortgage market (Freddie Mac, Wall Street, investors, etc.). So they don’t have a lot of long-term liability. As a result, your ability to afford the mortgage loan months or years down the road is not their concern. A harsh reality, but a reality nonetheless.

Some new federal rules require lenders to measure your ability to repay the mortgage debt. But this simply means they must ensure you have steady income, and that your debt-to-income ratio falls below a certain level (more to follow on this). This is a minimum standard imposed by the government. But you shouldn’t think of it as a home-buying budget. If you do the math to determine what you can afford to spend on a mortgage loan, you may find that your number is lower than the lender’s maximum approval about.

Related: How much can I borrow for a home loan?

In other words, it’s possible to get approved for a home loan that exceeds your comfort zone. Sure, you might meet the ability-to-repay requirement imposed by the government. But it might take all of your disposable income to meet this requirement. The last thing you want to do is use 100% of your disposable income on your mortgage debt obligation. That would leave you with no money for emergencies, savings account contributions, and quality-of-life expenses.

Housing Math: What Can You Afford in a Mortgage?

There’s actually an intelligent and systematic way to go about this. I recommend taking the following steps to find out what you can afford in mortgage payments:

Step 1 - Identity Your Net Monthly Income

Figure out how much money you earn each month. In this context, we are talking about your net income, also known as your take-home pay. We are less concerned with your pretax income (although the lender may use this when measuring your ability to repay). We are most concerned about your net income, after taxes have been taken out, because that is your usable income.

Step 2 - Add Up Your Monthly Expenses

Next, add up your recurring monthly expenses. For most people, this includes such things as car payments, credit card payments, personal loans, groceries, utilities and the like. These are things you spend money on, month after month. In order to determine what you can afford in a mortgage loan, you need to know what you’re paying out in other expenses.

If you are currently paying rent, you can leave that amount out of this calculation. Remember, your rent payment will disappear when you buy a house and take on a mortgage loan.

If you’re having trouble coming up with these numbers, you might want to take a look at your bank statements. This is a great place to start, because it will show where your money goes each month. It also shows you how much you’re spending on nonrecurring expenses, such as car repairs, household purchases and the like. It’s wise to use the average amount you spend each month on all expenses, recurring and nonrecurring. This gives you a more accurate picture of how much you’re spending each month, and what you can afford in mortgage payments.

Step 3 - Subtract Expenses from Income

Now you need to subtract your monthly expenses from your net monthly income. This is a starting point for determining what mortgage amount you can afford. But it’s not the number you should actually use. In this step, you’ve basically identified the amount of disposable income you have each month, after removing your rent or current housing payments from the picture.

Step 4 - Use a Fraction of the Remainder for Mortgage Payments

Some of this remaining amount will go toward your mortgage payment. But it shouldn’t all go toward the mortgage. You also need to leave some financial padding for emergencies, savings, and quality-of-life / entertainment expenses. If you use the entire remainder (identified in step 3 above) for your mortgage payment, you probably won’t even get approved by the lender. Most lenders will only approve you for a loan up to 43% debt-to-income ratio. We will talk more about this later.

I recommend using only 60% - 70% of your remainder on a mortgage payment. For instance, let’s say I subtract my expenses from my take-home pay, and find that I have $5,000 per month left over. I would be foolish to spend this entire amount on a monthly loan payment (and probably wouldn’t be approved anyway). If I set my housing budget at, say, 65% of this remainder, that would equate to a monthly mortgage payment of $3,250. That’s a reasonably sized payment, given the income used in this example. Sixty-five percent is not a hard and fast rule. It just illustrates the important point of using a portion of your remainder on a home loan.

The Perils of Being ‘House Poor’

I want to stress the importance of leaving some financial breathing room for yourself. If you put all of your disposable income toward a mortgage payment, you will essentially be ‘house poor.’ This means your house will soak up all of your income, to the point you have nothing left to spend each month.

• What happens if your car breaks down?
• What happens if you need a new washing machine?
• What if you want to take a vacation?

Being house poor puts you in a situation where you have to rely on credit cards for major purchases. People in this situation are statistically more likely to end up in foreclosure, down the road. The lucky ones can refinance or sell their homes, if the payments become unbearable. The unlucky ones end up defaulting on their loans and being foreclosed upon. And all because they didn’t leave themselves some financial breathing room. You need to account for this when determining what you can afford in mortgage payments.

Your budget is the most important number during the home-buying and mortgage process. The lender’s approval amount should be secondary to your budget. If you do the math and find that you can comfortably afford a monthly payment of $2,000 per month — but the lender says they will approve you up to $2,700 per month — an alarm should go off in your head.

This is a common scenario that happens to inexperienced home buyers. They are delightfully surprised that the lender is willing to give them more than they anticipated. They get tunnel vision and start looking at bigger and better houses. They forget about the budgeting process they used to determine what they can afford in a mortgage. And before they know it, they’re in a situation where they have no money left over each month, after making their mortgage payment. They have become house poor.

Debt-to-Income Ratio for Mortgage Loans

I want to revisit a topic I introduced earlier. It’s called the debt-to-income ratio, or DTI. This is a measurement used by mortgage lenders when qualifying applicants.

As the name implies, your debt-to-income ratio is a numerical comparison between the amount of money you earn each month, and the amount you spend on your various expenses. The lender will use your gross monthly income when determining your DTI ratio. This is your pretax income, which is different than the net income figures you used to calculate your budget.

There are two types of debt ratios used during the mortgage process. Your front-end ratio looks at your mortgage-related costs only. The back-end ratio combines your mortgage debt with all of your other recurring debts (credit cards, car payments, and anything else that shows up in your credit reports). Most lenders prefer borrowers to have a back-end debt ratio no greater than 43%. In fact, this has been written into the qualified mortgage rules that will take effect in 2014.

This means that if your combined debts (including the estimated mortgage payment) exceed 43% of your gross monthly income, you probably won’t be approved for the loan. But remember, your own personal budget is more important than any requirement the lender imposes. You need to determine what you can afford to spend on a mortgage loan before you even start talking to lenders.

Summary of key points:

• This article answers the question: What can I afford in monthly mortgage payments? This is a question that home buyers must answer for themselves, before they start shopping for a loan.
• It is your responsibility to determine where your financial comfort-zone lies. It’s not the lender’s responsibility.
• By law, the lender is required to verify and document your ability to repay the loan. This includes verification of income, assets and debts.
• In most cases, borrowers are limited to having a combined or back-end DTI ratio of 43%.
• You can calculate your affordability level by subtracting your monthly expenses from your net income.
• After subtracting expenses from income, you should leave some financial “padding” for emergencies, savings account contributions, and quality-of-life expenses.

It’s a Pity to Forget PITI

When determining what you can afford in a mortgage, you need to look at the full cost of the loan. Monthly payments on a home loan typically include four items — principal, interest, taxes and insurance. Collectively, these four factors are referred to as PITI. If you are using a mortgage calculator to break down the monthly cost of a certain loan amount, you must include the interest rate, property taxes and homeowners insurance. These things are typically rolled in to the monthly payment. (Remember, the full cost of your loan will partly be determined by the interest rate you receive.)

This article addresses the question: What can I afford in a mortgage loan? Despite the length of this tutorial, we have really only scratched the surface. I encourage you to research this topic beyond our website. Read as much information as you can find on the subject of mortgage loans and housing budgets. Make sure you have a very clear picture of what you’re getting yourself into, before you take on such an obligation.