Do I Earn Enough to Afford a $200,000 Mortgage?

Debt-to-Income Ratio and the 28/36 Rule

The 28/36 rule refers to two separate but related measurements of debt-to-income ratio (DTI)—the portion of your monthly income used to cover debt payments. Lenders use both versions of DTI to evaluate your ability to afford your mortgage payments and determine whether you qualify for a loan:

• The "28" part of the 28/36 rule refers to what's known as front-end DTI—the percentage of your gross monthly income (earnings before taxes and any other deductions, for example) represented by your housing costs. To qualify for most conventional mortgages, the monthly payment on the mortgage you've applied for cannot exceed 28% of your gross monthly income.
• The "36" portion of the 28/36 rule refers to what's known as back-end DTI, or the percentage of your monthly gross income used for all debt expenses, including mortgage payments. To qualify for most conventional mortgages, your total debt expenditures cannot exceed 36% of your gross monthly income.

As we'll see, several federally backed mortgage programs allow exceptions to the 28/36 rule, but these guidelines apply to nearly all conventional mortgages.

Other factors lenders look at include:

• Your credit score(s) and credit history: Loan applicants with higher credit scores generally pay lower interest rates on mortgages and other loans; those with lower scores may be charged higher interest rates and fees—both of which can mean higher monthly payments.
• The amount of your down payment: A down payment of 20% of the purchase price is the standard requirement, but many lenders allow borrowers with good credit to make lower down payments in exchange for higher interest rates or fees. When the down payment is less than 20%, the borrower is also required to purchase private mortgage insurance (PMI).
• Your savings or other assets: You might be able to withdraw savings or convert assets to cash to cover your monthly loan payments.
• The market value of the house you want to buy: Since the home you buy will secure your mortgage, its value is important to lenders.
• Your total debt: This includes the amount you pay each month in debt payments, and how much the payments on your mortgage will add to your monthly debt spending.

No matter how great your income is, you still may be disqualified based on other issues. It will likely prove difficult to get a mortgage if you have a recent bankruptcy on your credit report, for instance.

The lender uses the above factors to decide whether or not it will to lend to you and, if you qualify for a loan, the lender uses the same factors to determine:

• The amount it's willing to lend you.
• The length of your repayment period (how many monthly payments you'll have to make to pay off the loan).
• What interest rate it will charge on the loan.
• How much it will charge you in up-front fees, or "points," for issuing the loan.
• Whether you'll have to buy PMI. PMI is typically required if you're putting down less than 20% of the purchase price as a down payment.

Total loan amount, repayment period, interest rate and fees, and PMI (if any) all combine to determine your monthly payment amount.

What Income Do I Need to Qualify for a Mortgage?

To illustrate how some of these variables can interact to determine your income requirements, consider the example of a 30-year fixed mortgage on a home with a $230,000 market value, for which you're prepared to make a 13% down payment of $30,000—leaving a mortgage amount of $200,000.

At an interest rate of 4.8% (a bit higher than the current national average of 3.99%), your monthly payment (including PMI, which is necessary when you put down less than 20% of the purchase price) would be about $1,680.

Based on the 28% rule, which, requires that $1,680 payment to account for no more than 28% of your gross monthly income, you'd need a monthly income before taxes and other deductions of at least $6,000, or an annual gross income of at least $72,000, to qualify for that mortgage:

Minimum gross monthly income = $6,000; minimum annual gross = $72,000

As long as any monthly debt payments you have in addition to your mortgage payment are $480 or less, that annual income of $72,000 will also satisfy the 36% rule:

Minimum gross monthly income = $6,000; minimum annual gross = $72,000

If your monthly non-housing debts are greater, however, your total debt payments will exceed 36% of gross income and you'll need income to qualify for the mortgage.

Monthly debt expenses of $600 in addition to the mortgage payment would require a gross monthly income of $6,333 or an annual income of $76,000, for example:

Minimum gross monthly income = $6,333; minimum annual gross = $76,000

Monthly debt payments of $750 in addition to the mortgage would require annual income of $81,000.

Minimum gross monthly income = $6,750; minimum annual gross = $81,000

What Are Additional Costs Associated With Buying a Home?

Purchasing a home entails a major number of costs, some large and some less so. Many expenses associated with a home purchase, such as down payment, origination fees and PMI (if necessary) are incorporated into the final financing arrangements: The down payment is due at closing (with the exception of certain government-backed home loans, discussed below). Origination fees typically are due at closing as well, although some loan terms allow them to be "rolled up" into the monthly payment and paid out (with interest) over the life of the loan. PMI, when required, is incorporated into the monthly payment as well.

Additional one-time costs associated with a home purchase include:

• Fees for an appraisal, which is required by the lender to ensure the purchase price doesn't exceed the home's resale value.
• A property inspection (to ensure there are no undisclosed defects in the home before you finalize the purchase).
• Fees for a lawyer to review sales documents and attend the closing as your legal representative.

Recurring costs you may incur with the home purchase may include:

• A homeowners property/casualty insurance policy that covers the value of the home (typically required by lenders until the mortgage is paid off; policy premiums are often incorporated into monthly loan payments).
• Homeowners association (HOA) fees. The amount of these fees, and the services provided in exchange for them, vary among different associations. Some include trash and snow removal, landscaping services, maintenance of common areas such as a clubhouse, pool or racquet courts, and so on.

Note that any recurring expenses directly connected to the property you plan to purchase will be added to the mortgage payment for purposes of calculating your front-end DTI.

How Does Credit Affect Your Mortgage Affordability?

The first step a lender typically takes upon receipt of a mortgage application is a credit check—a request for your credit score and credit report from one or more of the three national credit bureaus (Experian, TransUnion and Equifax).

Lenders typically have a minimum credit score they're willing to consider when evaluating borrowers. Different lenders have different minimum score or "cut-off" requirements. Lenders use credit scores when deciding whether to offer a loan as well as when determining the fees and interest rates to charge.

In accordance with a widespread industry practice known as risk-based pricing, applicants with the highest credit scores typically are offered the lowest interest rates available. Those with lower credit scores are typically charged higher interest (and perhaps steeper fees as well). The basis for this is the fact that individuals with higher credit scores are statistically less likely than those with lower scores to miss payments and require lenders to initiate collections, foreclosure or other loss-prevention measures.

Mortgage lenders often offer numerous loan packages, with different interest rates and fees, targeted to borrowers whose credit scores fall within a specific numerical ranges—for instance, one offer for applicants with credit scores of 800 or better; another for those with scores of 720 to 799; and another for those with scores of 650 to 719. These are purely hypothetical examples; each mortgage lender sets its own credit score requirements.

What Are the Different Loans and Programs for First-Time Homebuyers?

While the 28/36 rule applies most conventional mortgage lenders, certain programs designed to help first-time homebuyers, veterans and certain low-income home buyers allow some exceptions:

• Mortgages backed by the Federal Housing Administration, known as FHA loans, are designed to help first-time homebuyers qualify for mortgages and allow back-end DTIs of up to 43%.
• Mortgages known as VA Loans, issued through the U.S. Department of Veterans Affairs, are geared toward veterans, service members and qualifying spouses, and allow back-end DTIs of 41%.
• The maximum back-end DTI allowed on USDA Loans—mortgages issued under guidelines set by the U.S. Department of Agriculture to help low-income borrowers buy homes in certain rural areas—is 46%.
• State and national programs designed to assist with homeownership may be able to help if you're having trouble meeting the down-payment requirements for a loan, or if your income falls below the level needed to secure some conventional loans.

The factors that determine the amount of a monthly mortgage loan, including your credit score and history and down payment amount, along with your monthly non-housing debt expenses, play a major role in determining how much income you'll need to afford a mortgage. Understanding DTI and the 28/36 rule can help you anticipate your needs and plan for the mortgage-application process.

If you need to improve your DTI, there are two things you can do:

• Increase your income. This often requires attaining a promotion and raise, or taking on a second job or "side hustle."
• Reduce your monthly debt expenditures. You can do this by paying down credit cards or paying off loans. Paying down debt can also help improve your credit scores and may mean you'll get more favorable payment terms you apply for a mortgage.

Naturally, applying both approaches at the same time compounds their effectiveness.

Buying a home is the biggest investment most people will ever make, but with resourcefulness and gumption, you can make it more affordable.