In light of all the silliness that went on in the mortgage market over the last few years, I thought it would be a good idea to write a post that focuses on how big a mortgage people can actually afford. It’s obvious from some of the articles I have highlighted over the past few days that lots of people threw caution to the wind and bought whatever the heck they wanted regardless of the consequences.
To compose this post, I’m using an example that was laid out in the book 10 Steps to Home Ownership (Affiliate Link). It’s an old book but I think her example still applies today. I’m also throwing out adjustable rate mortgages and the like and sticking to a 30-year fixed rate mortgage.
To seriously attempt to figure out how much a person can afford to spend on a mortgage requires several steps.
1. Calculate gross monthly income (GMI). This is pretty straight-forward. You simply add up your monthly income from all sources. In this example, we’ll assume a husband and wife who make $80,000 per year ($6,667 per month) combined. We’ll also assume that they both plan to continue working for the forseeable future.
2. Determine what percentage of GMI will go toward the monthly debt service. The author uses three different percentages (25%, 33%, and 36%). Of course, the lower the better so we’ll assume 25% for this example. At a GMI of $6,667 per month, this couple can afford to spend $1,667 on debt service, which includes other debt besides a mortgage.
3. Determine the MAXIMUM monthly mortgage payment. Using the same numbers found in Step 2, we’ll assume that the only other monthly debt this couple has is a $400 car payment. Subtracting that from $1,667 gives them a maximum monthly mortgage payment of $1,267. Budgeting software can help with this.
4. Subtract property taxes, homeowner’s insurance, and private mortgage insurance (PMI) from the maximum monthly mortgage payment to determine how much can actually go towards the mortgage. We’ll assume property taxes of $3,000 per year, homeowner’s insurance of $1,500 per year, and PMI of $50 per month for a total of $425 per month. Subtracting this from the $1,267 we found in Step 3, gives us a net monthly mortgage payment of $842.
5. Estimate the size of the mortgage. Using the chart below, estimate how much mortgage you can afford based on the net mortgage payment of $842 found in Step 4. Assuming an interest rate range of 6% – 7%, and a payment of $842, this couple can afford a mortgage of somewhere between $120,000 – $150,000. A lot depends on the interest rate. The lower the interest rate, the more house you can afford.
IMPORTANT NOTE: It’s important to note that this example did not include a down payment or closing costs. This was a calculation of the mortgage size only. That said, it wouldn’t be difficult to factor in those numbers into the equation. This example also did not factor in the tax deductibility of mortgage interest, which can reduce the monthly cost of the mortgage cost as long as you can itemize your deductions.
The Bottom Line
Lots of people were buying WAY MORE HOUSE than they could afford. They could have used a lesson in reality before they signed their life away.