Back in the U.S. housing boom in the early 2000s, mortgage money flowed freely, with many borrowers being qualified for more loan than they could actually afford. When the housing bubble burst and the entire economy took a hit, those same home buyers often had a hard time keeping up with their home loan payments and ended up in foreclosure.
Today, in the midst of the COVID-19 pandemic, millions of people have lost jobs or had work hours reduced. While lending regulations have been tightened since the Great Recession, it is still possible for home buyers to be approved for more money than they can reasonably pay back. For those looking to buy or refinance right now, it is important to ask yourself ‘how much of my income should I put toward a mortgage?’
The 28/36 Rule
Lenders use the 28/36 rule as a guideline to help qualify borrowers for home loans. The 28 is the front-end ratio and refers to a cap of 28% of your monthly pre-tax gross income that should be spent on your mortgage payment. That includes loan principal, interest, taxes and insurance. For example, with a monthly income of $4,000, you should not spend more than $1,120 each month on total housing costs. This has historically been a limit where most borrowers can comfortably make their payments and still have enough money for the rest of their expenses.
The back-end ratio of 36 refers to the maximum amount of a borrower’s income that should be dedicated to debt as a whole. This is also known as your debt-to-income ratio. Once you add up all your monthly debt obligations – car payments, student loans, credit card bills, etc. – and add in your potential mortgage costs, the total should not make up more than 36% of your gross monthly income. For example, if your monthly income is $4000, your total debt load should not come to more than $1,440 per month.
In some situations, the debt-to-income ratio is set higher. Fannie Mae and Freddie Mac allow DTIs up to 45% for conventional loans and the FHA allows up to 43% for its loans.
Just because there are limits set, that does not mean it is always safe to take out loans up to the maximum permitted. Every situation is different, and you will have to decide how much risk is acceptable. In this COVID-19 environment, is your job susceptible to hour reductions? Is your employment stable? If there were a change at work would you still be able to make your mortgage payments?
Beyond just the uncertainty of current conditions, there are plenty of other costs to factor in. Homeownership requires things like utility bills, repairs, maintenance and sometimes HOA fees, security systems and pest prevention. All these expenses need to be factored into your overall housing budget.
While there are general guidelines like the 28/36 rule, ultimately it will be up to you to determine how much of your income you feel comfortable devoting to your mortgage loan.