Affordability planning: how financing works
How do mortgage lenders know how much you can afford? How should you consider what they’re willing to lend you relative to what you can comfortably afford? Below we walk through how mortgage lenders derive the mortgage amount they’re willing to extend to help you come up with a number that may be more comfortable (as the lender is providing you the maximum).
The Basics of Mortgage Math
Mortgage lenders derive ‘qualification’ ratios to determine your borrowing ability. These ratios are based on your income, existing debt payments, and expected total housing payment. Here’s how they work:
Maximum Mortgage Payment (The Rule of 28)
This rule uses your monthly gross income (i.e. before taxes are taken out) and caps your mortgage payment at 28% of that figure. So if your monthly gross income is $10,000, your maximum monthly mortgage payment should be $2,800, and based on the prevailing interest rates, the maximum mortgage amount is determined.
Maximum Mortgage Payment = Monthly Gross (Pre-Tax Income) x 28%
= $10,000 x 28% = $2,800
Maximum Total Housing Payment (The Rule of 32)
Next, lenders consider your total housing payment, which includes mortgage payment in addition to homeowner’s insurance, private mortgage insurance (PMI), taxes, and association fees) and caps that figure at 32% of monthly gross income. Continuing our example, this figure is $3,200, meaning you can reasonably afford no more than $500 in monthly property taxes, HOAs, and PMI. Here, HOA payments for condos come into play throughout your search.
Monthly Gross (Pre-Tax Income) = $10,000 x 32% = $3,200
Maximum Taxes + Insurance + HOAs + PMI = $3,200-$2,800 = $500
Maximum Total Debt Payment (The Rule of 40)
This rule builds in total debts, meaning auto and student loans and credit card minimums and suggests a maximum figure of 40% of gross monthly income. Our example here means $4,000 and suggests no more than $800 in non-housing related monthly debt payments. If you’re considering buying a new car or have large student loans, this could prohibit your ability to obtain a mortgage.
Monthly Gross (Pre-Tax Income) = $10,000 x 40% = $$4,000
Maximum Total Monthly Debts = $4,000-$3,200 = $800
A Very Important Word of Caution
The above rules suggest the maximum affordability limits, but in no way should represent what you should borrow and pay. An absolutely critical exercise is to sit down and put together a monthly budget — as it stands today — and set a floor for the minimum amount you wish to save each month. For example, if you’re planning a wedding in the near future or starting a family, your expenses are likely to rise, and if you are saving for those items, it is likely more prudent to take on a lower housing payment. Only you can determine what amount fits your personal budget and you should in no way feel obligated to max your mortgage.