When it comes to buying a house or refinancing your mortgage, there’s a tendency to push the envelope as far as you can. Most people want to borrow as much money as they can on their homes so they’ll usually borrow as much as a mortgage lender will allow. This is especially true when purchasing a new home. You want the best house that you can afford, and that usually means stretching at least a little bit.
But when you’re taking a mortgage it’s very important that you have a reasonable amount of certainty that you will be able to make payment over the life of the loan. Pushing the monthly payment to the limit of your income may get you a bigger or better house, but it could have a negative affect on your finances. In fact, it might even leave you vulnerable should financial troubles hit at sometime in the future. This is why some people are better off avoiding 15 year mortgages.
What a mortgage lender will allow
As a general guideline mortgage lenders will allow you to take a house payment – that’s principal, interest, taxes and insurance, or “PITI” – of up to 28% of your stable monthly income. By “stable,” they mean income that is likely to repeat on a monthly basis in the foreseeable future, and they have their own ways of coming up with that number.
So if, for example, your stable monthly income is determined to be $5,000, your monthly allowable housing payment will be 28% of that, or $1,400.
That 28% figure isn’t set in stone either. Lenders will often allow you to exceed that figure if you have certain “compensating factors.” These include a large down payment, large savings reserves after closing, outstanding credit, or other sources of income that have not been used to qualify you for the loan. Because of these, a mortgage lender may actually allow you to buy a home with a house payment that is significantly above 30% of your stable monthly income.
Mortgage lenders also use a “total debt ratio,” that is the sum of your fixed monthly housing payment, plus monthly debts or other fixed obligations, such as alimony or child support. The general guideline for this ratio is 36% of your stable monthly income. But once again, with strong compensating factors, the lender may allow you to exceed that ratio as well.
Mortgage lenders may be too generous!
This is a good time to stop and consider some of the expenses that mortgage lenders do not include in your debt ratios.
On the housing payment side, lenders do not include monthly utility bills in your projected monthly house payment. Using the example above, if your basic house payment is $1,400 per month, and you have an additional $500 per month in utility expenses, you will be paying 38% of your income for housing ($1,900 divided by $5,000).
Other major expenses that are not reflected in the housing ratio or even in the total debt ratio, are childcare costs, health insurance premiums and income taxes.
Just because mortgage lenders don’t include these expenses in your debt ratios doesn’t mean you should ignore them. Forget about what the lender will allow – come up with a housing payment level and ratio that’s comfortable for you based on your own expenses.
Other factors to keep in mind
Some other factors you will want to keep in mind when you’re buying a house or planning to refinance, are outside factors that could have a material effect on your ability to make your house payment.
One question you need to address is, how stable your employment will be? It’s never possible to know precisely what your future employment prospects are, but if you are in a career field that is experiencing turmoil, or if you are in one that may require you to make a geographic move, you may want to be more conservative in the size of your house payment.
If a job loss within the next year or two is a reasonable possibility, you may want consider keeping your house payment low enough that you will be able to afford to make the payment with a reduced income.
Still another possibility are your outside interests. If you want to payoff debts, increase your retirement contributions, save money for other purposes, or have hobbies and activities that you participate in, a large house payment would interfere with these plans. If any of these are true, you will want to reflect that reality in your new house payment.
Deciding on your own safe house payment amount
After considering all of the above, you may want to lower your house payment to a more conservative level. While the mortgage lender may allow you to use 28% of your stable monthly income, based on your other expenses and non-housing plans or activities, you may want to lower that payment level accordingly.
To compensate for spending money in other areas of your financial life, or to prepare for the possibility of a lower income in the future, you may decide to commit only 20% of your monthly income to house payment, or even to go low as 15%.
The more conservative you are with the payment that you are prepared to accept, the more flexibility you will have going forward, and the more you’ll be prepared for whatever happens in life.
When it comes to buying house, it can really help to keep your feet on the ground.