Anyone that is considering buying a house will need to know how much they can afford to spend on their mortgage payment each month. This simple sounding question can actually cause some confusion though. The amount you think you can spend each month on your house will likely be a different number from what your lender says you can afford.
You'll be restricted by the number your lender gives you, even if you think you can afford to spend more each month on your mortgage. However, there are some steps you can take ahead of time to increase this number as much as possible if you want to buy a more expensive home. I've put together this post to help you figure out how much you can afford to spend and how to increase that amount.
Income Based Payment Limits
When you earn money from a paycheck, your lender will look at your gross earnings to determine a base number for how much you can spend on your home loan each month. If you are self-employed, your net profits will be used for this calculation. Regular employees can simply show pay stubs for a certain period of time to prove their income. However, if you work for yourself, you will have to provide the last two years of tax returns.
Being self-employed, it is actually much more difficult to get a mortgage. Your net profits used to calculate your income are the numbers used on the last two tax returns. You'll need a successful business for at least two years, and you'll have to pay taxes on those profits. The profits from both years are averaged together to calculate a monthly income for you. This can be frustrating when you make some money the first year in business and then make a lot in your second year because your average number may still be too low to get a mortgage even though you could afford a much higher monthly payment.
Once you know your monthly income number to use for this calculation, multiply that number by 0.28 to get your maximum mortgage payment limit. This is 28% of your gross income or self-employment profits. The result you obtain from this calculation is just a base number to work from though. We will next need to take a look at debt to see if this number needs to be modified.
Your debts also have to be factored into your monthly mortgage payment limit. In general, the more debt you have then the less you'll be able to afford to spend on your house payment. However, this part of the calculation can also be more confusing and less clear-cut than the previous one. Different lenders and different types of home loans can vary when it comes to debt-to-income (DTI) ratios.
Thirty-six percent is the ideal target. Take the same income number you obtained in the previous section and multiply it by 0.36. This is the limit you should be spending each month on your debt payments AND your mortgage combined. If you want to max out your mortgage payment at 28%, then this leaves you 8% of your income that can go towards debt.
Now it gets a bit more complicated. There are some lenders and types of home loans that may let you have a higher DTI ratio. It's possible to go as high as 45% with many types of loans and even 50% with some. This number could be lower if you have bad credit though. Each lender will look at your unique situation to determine a final DTI limit to use for your application. Ultimately, you will probably need to talk to your lender to find out exactly what number they will use for you, but you can still use the numbers here as a rough guideline.
How is DTI Calculated?
I'm really good with numbers, but even I misunderstood how DTI worked and was calculated when I obtained my mortgage. For this reason, I want to help shed some light on this subject to help you out. If you have a monthly budget, you probably know exactly what you spend each month. Your actual spending doesn't entirely matter when it comes to DTI ratios though. To complicate it even more, sometimes a lender will say you have a monthly payment that you don't actually make each month.
DTI is mainly based on three things: debt that shows up on your credit report, your future monthly mortgage payment based on a purchase price and down payment amount, and government debt. What you spend on food each month at the grocery store doesn't count towards DTI. Neither does your cell phone bill or your electricity payment. A credit card with a balance will count towards DTI. Personal loans and car payments on your credit report count too. If you owe the US government money, such as for an existing tax debt, that will also count.
Trying to get approved for my mortgage, I was thrown off by collection accounts. I had a few old accounts in collections from 5+ years prior, back when I didn't pay attention to my credit score. These accounts were close to being cleared off my record and weren't legally even collectable anymore, so I wasn't paying them.
When my mortgage lender calculated my DTI, this debt was included. A magical, non-existent monthly payment was assigned to each debt and those raised my DTI higher than I had expected it to be. Luckily, the house I was buying would have a payment less than 20% of my business profits, so I had some wiggle room with my overall DTI and still got approved.
Calculate Monthly Mortgage Payments
Trying to figure out exactly what your house payment will be each month can be close to impossible without your lender giving you exact numbers for your loan. However, you can usually guess this number with a bit of work. Your goal here is actually to figure out an upper limit to try to limit your purchase price to ensure you get approved.
I recommend calculating your DTI without your house payment included - just use the numbers that you know and be sure to account for collection or government debt too. If you know your debt is 10% of your income, you can subtract that from 36% and also 45% to get a rough idea of a mortgage payment range. However, keep in mind that this number shouldn't be higher than 28%. In this hypothetical 10% debt situation, you don't have the potential to have a 35% house payment just because you have low debt - you'd still max out at 28%. With a house budget percentage, you can work backwards from your income to determine a rough purchase price range.
Mortgage payments can be tough to figure out exactly for a few reasons. You don't always know how much you will pay for your house unless you have an accepted offer already. The purchase price minus your down payment amount is the amount to be financed. That amount to finance is used to calculate a mortage payment based on the exact interest rate a lender will give you based on your credit. Without knowing the purchase price or the exact interest rate, you can't figure out an accurate payment amount. Then you have to consider homeowner's insurance and property taxes. These are also included with your mortage payment amount.
What Can You Really Afford?
Any number you figure out using the information here will likely not be exact. Even when you get an exact number from your lender, the real question is whether you can really afford it or not. Just because the lender says you can doesn't mean that is necessarily true. Remember, their calculations only figure in your debt and house payment. They don't look at or consider your other monthly spending.
In theory, the lender's max monthly payment amount is something that you should be able to afford if you don't spend too much money on other things. If you get into a situation where you struggle to pay your house each month, look at your other spending to make cuts to save money.
Before you sign a mortgage, ask yourself if you can really afford that payment each month without altering your current lifestyle. If changes will be necessary to make the payment, ask yourself whether you're willing to make those changes to get the house.
Should You Spend Less Than You Can Afford?
One final factor that's worth thinking about is whether you should actually spend as much as the lender says you can afford. My monthly mortgage payment is about 16% of the net profits of my businesses, my only source of income. I could've bought a house that cost about 75% more. My house did cost more than the national average, so it's not a cheap house, but my income level keeps the percentage low. Why didn't I buy a more expensive house? I didn't want to be house poor and have all of my money tied up in my mortgage payments.
I like investing and running my own businesses. Some of my businesses have a lot of monthly expenses that I have to worry about paying. A few of my side hustles have a very steady income, while others look like an insane roller coaster ride on a graph. As a result, my cash flow can vary a lot from month to month, so I try to keep my expenses low in certain areas when possible.
What is your lifestyle and what do you like to spend your money on each month? If you want more expendable income each month, simply go for a cheaper house and lower monthly payment. Maybe you want to be able to take vacations and need to save for them. Perhaps you dream about making renovations to your new home to make it perfect for you and don't want to finance those renovations. Your house payment will likely be your largest expense each month, so keeping it reasonable is one of the easiest ways to free up income for other purposes. With a mortgage, you're locking in that spending lifestyle for 30 years too.