If you’re shopping for a new home, you need to know how much home you actually can afford—understanding your limits will help you to focus your home search on properties within the correct price range, even before you apply for a mortgage.
You’d think this would involve a complicated calculation involving several years’ worth of tax returns, and possibly an advanced degree in economics. But in fact, learning your home-buying limits takes just a couple of minutes and some easy math.
Mortgage Rule of Thumb
The most important factor that lenders use as a rule of thumb for how much you can borrow is your debt-to-income ratio1, which determines how much of your income is needed to pay your debt obligations, such as your mortgage, your credit card payments, and your student loans.
Lenders typically want no more than 28% of your gross (i.e., before tax) monthly income to go toward your housing expenses, including your mortgage payment, property taxes, and insurance. Once you add in monthly payments on other debt, the total shouldn’t exceed 36% of your gross income.
This is called “the mortgage rule of thumb,” or sometimes “the rule of 28/36.”
If your debt-to-income ratio exceeds these limits on a house you’re considering buying, then you may not be able to get a loan, or you may have to pay a higher interest rate. There is an exception if you’re interested in a qualified mortgage. In that case, the acceptable debt to income ratio maximum would be 43%2. A qualified mortgage3 is one that meets certain guidelines in which a lender determines your ability to repay the loan.
Calculating Your Debt-to-Income Ratio
Calculating your debt-to-income-ratio isn’t difficult. The first thing you need to do is determine your gross monthly income — your income before taxes and other expenses are deducted. If you are married and will be applying for the loan together, you should add together both your incomes.
Then take the total and multiply it first by 0.28, and then by 0.36, or 0.43 if you’re angling for a qualified mortgage. For example, if you and your spouse have a combined gross monthly income of $7,000:
- $7,000 x 0.28 = $1,960
- $7,000 x 0.36 = $2,520
- $7,000 x 0.43 = $3,101
This means that your mortgage, taxes and insurance payments can’t exceed $1,960 per month, and your total monthly debt payments should be no more than $2,520, mortgage payment included.
Unfortunately, you need to keep your monthly payments under both of these limits. So the next step is to see what effect your other debts have. Add up your total monthly non-mortgage debt payments, such as monthly credit card or car payments.
For this example, we will assume your monthly debt payments come to $950. Computing the maximum mortgage payment:
- $2,520 – $950 = $1,570
Since in this example you have relatively high non-mortgage debt, you’re limited to spending $1,570 on a mortgage, taxes, and insurance for a new home. If, on the other hand, you had only $500 in non-mortgage monthly debt payments, you could spend the full $1,960 on your home, since $1,960 + $500 = $2,460 (or less than your overall monthly payment limit of $2,520).
Why Does Debt-to-Income Ratio Matter?
You may be wondering why the debt-to-income ratio is important, beyond determining how much you could qualify for when getting a mortgage. There are two important reasons.
First, knowing your DTI ratio can help you gauge how much home is truly affordable, based on your current income and existing debt payments. While you may be approved for a $500,000 mortgage based on strong credit and a solid income, for example, paying $3,000+ for a mortgage each month may not be realistic if you have substantial student loans or other debts you’re paying off. Buying a larger mortgage than you can truly afford is a good way to end up house-poor.
Second, the mortgage rule of thumb offers reassurance to lenders that you can, in fact, repay what you’re borrowing. Remember, lenders make money on mortgage loans by charging interest and fees. They want to have a measure of certainty that they’ll be able to collect interest payments for the life of the loan. Your DTI ratio, along with your credit history and assets you have in savings or investments, give lenders a better idea of how able and how likely you are to repay a mortgage.
How to Improve Your Debt-to-Income Ratio for a Mortgage
If you’ve calculated your debt-to-income ratio and the number isn’t quite where you’d like it to be to purchase a home, there are some things you can do to improve it. As you prepare to apply for a mortgage, use these tips to manage your debt-to-income ratio:
- Pay down your highest balance credit card, or pay smaller amounts to all of your credit card accounts.
- Consider a debt consolidation loan to combine credit cards or other debts at a single interest rate.
- Avoid incurring new debt during the window of time leading up to applying for a mortgage and before you’ve closed on a home.
- Consider ways you could increase your household income, such as negotiating a raise, taking on a part-time job, starting a side hustle or seeking a higher-paying role with a different employer.
