Life is full of rules. Whether it’s the golden rule, the rules of the road or the life-changing rules in the latest trending self-help book, we are on a constant lookout for common-sense rules to help us navigate life’s complexities.
And speaking of complexities, buying a home can feel more complicated than driving, dieting or decluttering. You worry about whether your income will cover the mortgage payments. And you worry about getting approved for a purchase that will cost hundreds of thousands of dollars over the next 10 – 30 years.
We get it, but don’t stress. There are actual rules of thumb that can help you figure out how much income you really need to buy a home.
These rules are based on:
- Current realities of the mortgage process
- The debt-to-income ratios used by mortgage lenders to determine your eligibility for a loan
- Personal finance best practices designed to foster a healthy balance between spending today and saving for tomorrow
How Much Income Do I Need To Buy a House: Then vs. Now
If you’re thinking about buying your first home, you’ve probably been asking lots of questions like these:
- Am I making enough money to afford a home?
- How much home can I afford?
- What percentage of my income can I spend on my mortgage?
And you’ve probably been getting lots of conflicting answers from parents, older relatives and friends.
The first rule is knowing that the rules that worked in the past aren’t the same rules that work today.
Buying a house … then
In the past, buying a home was simpler. Interest rates were high, but salaries and home prices were in alignment and student loan debt was less of a factor.
If you wanted a mortgage, you would work steadily for a few years and save up for a 20% down payment. Back then – with lower home prices, higher interest rates on savings accounts, less personal debt and more stable employment – this was actually doable.
Once that was said and done, you’d go to your local bank or credit union, fill out a loan application and probably accept whatever offer they made on a 30-year, fixed-rate mortgage. If you already had a few years of work experience, the bank would assume that you’d earn a steady income for the next 30 years.
Buying a house…now
That was then, and this is now.
- Housing prices have risen dramatically, and incomes haven’t kept pace
- Student loans and other personal debt eat up a larger share of available income
- The economy is increasingly driven by self-employment, job instability and frequent career changes
- Interest rates are at historic lows, making it easier to afford a mortgage but harder to save for a down payment
- Financial technology (fintech) apps have made the mortgage process more competitive and transparent
Earning Potential: The New Rules of Mortgage Income Requirements
The ‘do I need an income to buy a house?’ rule
The short answer is yes.
Before the 2008 financial crisis, lenders could offer mortgages to people without checking their income or ability to pay their mortgages. In hindsight, this proved to be a bad idea.
Through regulation and hard lessons learned, mortgage lenders are now more cautious about considering income before offering a mortgage and will require documents like paystubs or W-2s for proof of income.
The steady income rule
Getting a mortgage is a long-term commitment, so lenders prefer to see at least 2 years of steady income before they offer you a mortgage. Of course, this made more sense back in the day, when people could expect to work for a single employer or in a single profession for most of their lives.
Today, more and more of us are freelancers, self-employed or independent contractors. Showing a lender that you can consistently make your mortgage payments is more challenging than it used to be, but it’s not impossible.
Show 2 years’ worth of income
Unlike your parents, lenders don’t care if you enjoy what you do for a living. As long as you’re earning an income, they’re happy. Try to demonstrate 2 years of steady income – which includes any money you’ve earned driving for a ride-share or making deliveries.
Work at least one job with a paystub
You may make more money with your creative freelance job than you do with your “survival” job, but that survival job leaves a paper trail that is easier for lenders to follow. Being able to show that you have a steady income, even part-time, can help lenders trust you because they’ll know you have an income, even if your freelance work dries up.
Count all your income
If you’re exclusively self-employed or earn a significant portion of your income through tips, bonuses or commissions, make sure you keep good records of your income and expenses. Lenders will base your income on a 2-year average.
Build excellent credit
An excellent credit score counts for a lot, whether you do or don’t work 9 – 5. Aim for a credit score of 620 or higher, which is the minimum credit score needed for most conventional loans. And the higher the credit score, the better your mortgage terms and interest rate may be.
Alternate sources of income count
Keep in mind that you may have other sources of income that don’t appear on a paystub. These can include:
- Rental or property income
- Pension or annuity income
- Social Security and disability benefits
- Alimony or child support payments
- Trust fund income
- Investment income
- VA benefits
- Foster care payments
Different lenders will weigh these types of income differently. You may need to demonstrate that you’ve received this income steadily for a year or more, depending on the source of income and the type of loan you’re getting.
Percentage Power: The New Rules of Income-Based Home Buying
Once you’ve established that you have an income, can make some kind of down payment and are able to pay a monthly mortgage, it’s time to apply the rules to see how much of a mortgage you can get approved for based on your income in relation to your debts.
Here’s where the new rules of thumb really kick in. Buckle up – there’ll be some math involved!
The 28% mortgage payment rule
The first rule is that your mortgage payment (interest and principal) should not exceed 28% of your monthly gross income.
Let’s say you earn $60,000 a year.
Monthly gross income: $5,000 x 28%
Maximum mortgage payment: $1,400
Remember that $1,400 includes both principal and interest, so the amount you can borrow will depend on the terms you can get.
With a 3% interest rate, you can afford to borrow up to $330,000.
A $1,400 mortgage payment at 4% allows you to borrow about $290,000.
Every .25 percentage point difference in your mortgage interest rate can change the amount you can borrow by roughly $10,000.
Even if you can afford to borrow $330,000, the next few rules will show why you may not want to.
The 32% total housing payment rule
It’s important to remember that the cost of a home isn’t just the mortgage payment. There are other factors that will affect the amount of income needed to get a mortgage.
Homes come with non-mortgage home expenses like:
If you can’t make a 20% down payment, expect to pay for private mortgage insurance. This can cost an average of 1% of the loan’s value each year until you’ve paid 20% of your loan balance off. The amount is usually divided by 12 and added to your monthly mortgage payment.
This can vary based on a home’s price and location. According to Business Insider, you can expect to pay an average of $1,000 per year for a home valued between $100,000 and $300,000.
These taxes can vary widely from state to state and county to county. According to one report, rates can range from 0.6% of the home’s value in Alabama to 2.5% in New Jersey. Of course, property taxes help support your community. So while they may add to your monthly budget, there can be value in paying more in property taxes if you want more community amenities and better schools.
Homeowner association fees
If you live in a condo or planned community, you may need to pay a monthly fee to a homeowners association or property management company. These fees cover common area maintenance, as well as other services, and can vary based on the community.
OK, let’s crunch some numbers.
Let’s assume you live in Michigan, which has middle-of-the-road property taxes and average home values. You have a $200,000 mortgage on a house valued at $220,000.
PMI: Loan Value x 1% = $2,000 per year or $166 per month
Homeowners insurance: $1,000 per year or $83 per month
Property taxes (Michigan): Home value x 1.58% = $3,476 per year or $289 per month
Total monthly non-mortgage home expenses: $538
In total, these non-mortgage home expenses plus your mortgage payment shouldn’t exceed 32% of your income.
Again, let’s say you earn $60,000 a year.
Monthly gross income: $5,000 x 32%
Maximum total home expenses: $1,600
Non-mortgage home expenses: $538
Total mortgage payment: $1,062
With a 3% interest rate, you can afford to borrow up to $250,000.
As you can see, if you live in an area with high taxes or you’re paying for PMI, you may need to adjust how expensive of a home you plan to buy.
But what about your other debts?
The 36% to 40% total monthly debt rule
If you have other monthly debts, like car payments, student loans and minimum credit card payments, these can also affect how much mortgage you can afford.
When you’re looking for a mortgage, lenders will look at these debts compared to your income. This is often referred to as your debt-to-income ratio (DTI), and it shouldn’t exceed 36%, especially before you buy a home.
The higher your DTI before you get a mortgage, the less likely lenders are to consider you for a conventional mortgage.
As a general rule, when you add your other monthly debts to your total monthly home expenses, your DTI shouldn’t exceed 36% to 40% of your monthly income.
Again, let’s say you earn $60,000 a year.
Monthly gross income: $5,000 x 40%
Maximum total monthly debt: $2,000
In the example above, you want to make sure that your monthly mortgage payment and other debt payments do not exceed $2,000. If you follow these rules, you’ll see that the amount you can borrow depends on more than just your income.
To Meet the Income Required for a Mortgage: Use the 50/30/20 Rule
The 50/30/20 rule was popularized by Senator Elizabeth “nevertheless, she persisted” Warren in her book All Your Worth: The Ultimate Lifetime Money Plan. The senator advises that you divide up your income like this:
50% Needs / 30% Wants / 20% Saving and Investing
The “needs” category is things you must pay for in order to live – and to avoid debt collectors. Your mortgage and debt payments will fall under the “needs” category. If you follow the 28%, 32%, and 36% – 40% rules, you can meet your obligations every month, including paying down debt, and still have some leftover for other needs, including groceries, gas and utilities.
That leaves you with 30% of your income to pay the rest of your expenses – like entertainment, clothing and dining out – as well as 20% to build an emergency fund and invest in your future.
The final rule: Avoid Murphy’s law
If there is one rule that holds true, it’s the old standard we know as Murphy’s law, which dictates that whatever can go wrong, will go wrong.
Your best chance of avoiding the worst consequences of that rule, especially when it comes to income and mortgages, is to make informed decisions. That will help you balance the risks and rewards of homeownership while making sure you can build a stable financial future.