What Percentage of My Income Should I Use for a Mortgage?

Summary: This article explains what percent of your income you can put toward a mortgage loan. It also explains the debt-to-income ratio, or DTI, and how this criteria will affect you during the application and approval process.

The number 43 has been popping up in mortgage circles lately. For instance, a new rule announced last month by the Department of Housing and Urban Development (HUD) requires tougher screening for FHA borrowers with debt-to-income ratios above 43 percent.

That number also appeared within the finalized text of the qualified mortgage (QM) rule, issued in January 2013. According to the Consumer Financial Protection Bureau, the federal agency that issued the rule:

“the general [QM] rule requires that monthly payments be calculated based on the highest payment that will apply in the first five years of the loan and that the consumer have a total (or ‘back-end’) debt-to-income ratio that is less than or equal to 43 percent.”

Banking regulators appear to be drawing a line in the sand. As a result, mortgage lenders will limit you to using a certain percentage of your income for mortgage payments — 43 percent in most cases.

Calculating the DTI Ratio

When you apply for a home loan, the lender will review every aspect of your financial situation. They will evaluate your current income and debt situation to come up with your debt-to-income ratio, or DTI. This is an important number during the mortgage application process. By itself, it has the power to sway the lender’s decision for or against you.

As the name implies, the debt-to-income ratio is a numerical comparison between the amount of money you earn each month and the amount you pay to cover your debts. This number is expressed as a percentage. For example, if half of your monthly income goes toward your various debt obligations, you have a DTI ratio of 50 percent.

Where mortgage loans are concerned, you actually have two DTI ratios:

• The front-end ratio compares your gross monthly income to your housing-related debts (mortgage principal, property tax, homeowners insurance, etc.).
• Your back-end DTI ratio works on the same principle, but it takes into account all of your combined debts. On the back end, the lender is concerned with your mortgage payments, credit card payments, car payments, and any other recurring debts you have.

It is the total, or back-end, DTI ratio that matters the most in terms of mortgage approval versus rejection.

You asked the question, What percent of my income should I use for a mortgage loan? In reality, there are two different questions you must consider:

1. How much can you comfortably afford to pay each month toward a mortgage payment? That question is addressed here.
2. What percentage of your income will the lender allow you to put toward a mortgage payment? That question is covered below.

I want to emphasize the point that these are two different considerations. You should set a budget for yourself before you even start talking to lenders. You would do this by subtracting your monthly debts from your monthly take-home pay, and working down from that number. The debt-to-income ratio is a related concept, but it has more to do with mortgage approval that affordability. In other words, it’s possible for you to be approved for a home loan that exceeds your financial comfort zone.

General Rule: 43 Percent of Income for Mortgage Approval

The Federal Housing Administration (FHA) also has limits on the percentage of income you can put toward your mortgage payments. Here again, the 43-percent rule emerges as a rule of thumb.

In January 2013, the FHA announced a new rule regarding borrower credit scores and debt ratios. Here’s what it says in a nutshell: If a borrower has a credit score below 620, and a back-end DTI ratio above 43%, the lender must manually review the application. They must also find a document compensating factors that make up for the less-than-ideal debt scenario.

Translation: If you are using an FHA loan to buy a house, and you would end up using more than 43 percent of your income for your total debts (including the mortgage loan), you’ll have a harder time getting approved. The lender will have to manually underwrite the loan, which means you cannot be automatically approved through the FHA’s automated underwriting system. You can learn more in this article.

It’s also worth mentioning that the qualified mortgage (QM) rule has a 43 percent debt-to-income provision. The federal government seems to be drawing the line at 43 percent, as far as the percentage of income you can put toward mortgage debts and other debt obligations.

Some “experts” recommend putting a certain portion of your income toward a mortgage payment. It is usually some arbitrary percentage. For example, you mentioned that your sister recommended 33 percent. But this is a flawed approach. It is much better to do the math all the way through, starting with your monthly income and debt obligations.

You should be more concerned with mortgage affordability than approval. A mortgage lender may approve you for a loan with a debt-to-income ratio up to a certain point. But that doesn’t automatically mean that you can comfortably afford the monthly payments. Always remember that affordability and approval are two different things.