The traditional way to see how much of a mortgage payment you can afford is to take your monthly income and multiply it by 0.28. So if your monthly income was $5,000 this formula would say you can afford a $1,400 a month house payment. So someone with a $60,000 annual income could afford a $1,400 mortgage by their self. A couple with a $120,000 annual income and $10,000 monthly income could afford a $2,800 monthly house payment according to this formula.
A debt to income ratio of 36% or less helps you get approved for the loan. This is all your monthly debt payments including your new mortgage payment divided by your monthly income. Remember that your mortgage payment is not just your loan but includes your home insurance, property taxes and Home Owners Association fees.
Now let’s look at the 3-30-10 rule for buying a house.[1]
3-30-10 Rule for Buying a House
How much house can I afford?
If you really want to keep your personal finances easy to manage don’t buy a house for more than three times(3X) your income. If your household income is $120,000 then you shouldn’t be buying a house for more than a $360,000 list price. This is the price cap, not the starting point. This can seem impossible to do in many major cities and it likely is which shows that it may not be the best financial decision to live in those cities if you don’t want house payment stress.
There are the same types of jobs all over the country and you don’t have to live in high cost cities that put a strain on your personal finances. This rule makes for a low stress house payment. This is a smart and frugal rule and makes sense even more in this current high interest rate environment.
How much should a down payment on a house be?
The 30 in the rule stands for saving up 30% of the purchase price of the home before buying it. So if you bought a $300,000 house you would put 20% or $60,000 down at closing on the cost so you would remove the PMI expense. This is the cost of buying private mortgage insurance for your bank so if you are foreclosed on, they are protected, a complete waste of your own money. The other 10% or $30,000 in this example goes into savings as an emergency fund for you. This ensures your ability to pay the mortgage for over a year or longer depending on your interest rate.
What percentage of income should go to mortgage?
The final part of the formula, the 10 means to spend no more than 10% of your gross income on your mortgage payment. This is very difficult in a high interest rate environment and requires a 30 year mortgage, a high income, and living in an inexpensive area in a modest home. Another way to do this is to have a roommate that pays you rent, have a separate Airbnb area, or own a duplex and live in one side and rent out the other.
This is what some people do that are willing to do whatever it takes to achieve their financial goals. It will seem extreme to the majority of people. So if your household gross income is $10,000 a month your mortgage should be $1,000 a month according to the 3/30/10 rule. Large down payments can also help make a payment lower.
In contrast, the normal percentage of income ordinary people spend on their mortgage is 28%.[2]
Mortgage 15 year vs 30 year
The pros and cons of the two different time durations of mortgage loans has become more nuanced in the current interest rate environment. Traditionally the 15-year mortgage is preferred when possible as it’s paid off in half the time and saves the interest off 15 years of additional payments. Some money managers have argued to always get a 30-year mortgage when interest rates were low because you could make more money investing the difference of the lower payment in the stock market during the perpetual bull market. This is currently a different world with high interest rates near 7% for a 30-year mortgage and a bear market plunge over the past 12-months.
Home owners are almost always tempted to go with the lower 30-year mortgage and be able to buy a bigger house. A 15-year mortgage is more difficult to make payments on but will pay off and have no payment after 15 years if the home is kept. With a 15-year mortgage you accrue home equity much faster and it’s half way paid off after 7 and a half years.
However for the 3/30/10 rule you need a 30-year mortgage to keep the payments as low as possible to try to get the 10% income expense ratio. People that have previously locked in low interest rate mortgages before 2022 have created a great hedge against inflation over a long period of time.
Can mortgages be paid off early?
Yes, most mortgages can be paid off early without a penalty. Everyone needs to make sure when they call their mortgage lender to payoff the remaining principle on the loan to ask if there will be any penalties. If the loan is paid off early through extra payments being made then you must ensure to mark the check or payment as going on the “principle only” and make sure they know it isn’t just an early payment that goes toward the total loan. The benefit of paying off a mortgage early depends on the interest rate and stock market returns.
Can mortgages increase?
An adjustable rate mortgage (ARM) can increase or decrease correlated with interest rates due to the way the loan is structured in time phases. A fixed-rate mortgage payment can also fluctuate during the time frame of the loan due to factors like the cost of insurance on the home and city or county property taxes. The bank loan part of the fixed rate mortgage stays the same but the other factors and also the money kept in the escrow account can cause the mortgage payment to change once a year.
