TL;DR: You should try to spend no more than 35% of your gross (pre-tax) income on your mortgage. A more conservative recommendation is no more than 25% of your gross income.
If you are currently in the market for a house you will first need to figure out exactly how much you can afford.
There are a lot of costs that go into buying a house and even a scrupulous planner can get overwhelmed by costs if they don’t plan properly.
In order to figure out how much you can afford to spend on a house, you will need to figure out:
- Your gross income
- Total expenses
- Net cash flow
- How long of a mortgage you want
All of these factors go into determining how much you should be paying each month on your mortgage.
Before we go into specific recommendations for mortgage payments, we’re going to cover the major types of mortgages and how monthly mortgage payments are calculated.
What Is A Mortgage?
A mortgage is a kind of loan that is used to finance a property. A mortgage is a “secured” loan, which means that the person who borrows promises some kind of collateral in the event they cannot repay that loan in a timely manner. In the majority of cases, the collateral for a mortgage is the property itself.
Both individuals and businesses use mortgages to finance properties.
The benefit of a mortgage is that it gives you a way to buy some property without having to shell out the entire cost upfront.
Over many years, the borrower pays back the loan plus interest in a series of installments.
In the case when the borrower cannot repay the loan, the mortgage owner has the right to foreclose the property and sell it off to make up the debt.
A mortgage is a specific type of loan, but not all loans are mortgages. The key aspect of mortgages is that they are secured loans and come with some kind of collateral.
Even when you have the funds to pay for the property upfront, it can still be a good idea to secure a mortgage. For example, securing a mortgage can free up funds that you can put into other real estate investments.
There are two major payment components to a mortgage. The monthly principal is the main amount you owe each month and is determined by the amount of the mortgage and the length of the loan terms.
The interest rate is what the lender charges you for the loan. Other components may include homeowners insurance and taxes. In other words, your total monthly mortgage payment should look something like this:
Principal + interest + homeowners insurance + taxes = total monthly payment
Types of Mortgages
Not all mortgages are the same. The types of mortgage differ depending on the length of the repayment period and the interest rate for each payment period. The most common kinds of mortgages are 15 and 30-year mortgages, meaning that the borrower has 15 years or 30 years to pay off the loan, respectively. Some mortgages are only for 5 years while others can last as long as 40 years.
What Is A Fixed-Rate Mortgage?
With a fixed-rate mortgage, the borrower promises to pay a static interest rate over the time of the loan. In a fixed-rate mortgage, the monthly principal and interest rate stays the same over the entire life of the loan. Even if market interest rates rise, the monthly payments do not change. 15-year fixed and 30-year fixed mortgages are probably the most common kinds of mortgages.
What Is An Adjustable-Rate Mortgage?
With an adjustable-rate mortgage (ARM), the interest rate can fluctuate depending on the market. If the market interest goes up, then monthly payments go up and if the market interest goes down, then monthly payments go down.
ARMs can be a double-edged sword. One the one hand, if the market rate goes down, then payments become more affordable. But if the market rates increase too much, you might not be able to make your monthly payments. Generally, the initial interest rate of an ARM is slightly below the market rate, which makes ARMs more affordable in the short term but potentially more expensive in the long term.
There are other kinds of mortgages like interest-only mortgages and payment-option ARMS, but these other kinds of mortgages have complicated repayment schedules and are best left to experienced borrowers and investors. In fact, a lot of homeowners got backhanded by the 2008 financial recession by speculating on these kinds of mortgages.
What Are Reverse Mortgages?
Lastly, there are so-called reverse mortgages. These kinds of mortgages are reserved for older seniors who want to transfer part of their quality of a home into cash, hence the term “reverse.”
By borrowing against the value of their home, homeowners can receive money as monthly payments, a line of credit, or a lump cash sum.
Finding the Right Mortgage
Before even getting a mortgage you must first have the finances to qualify for the loan. Lenders will check your:
- Gross income
- Employment status
- Outstanding debts
- If you have financial dependents
Lenders will also base their decision on things like:
- Credit history
- Property value
- Initial deposit
You must also put down an initial deposit on your mortgage. The larger the initial deposit, the lower your monthly payments will be and the faster you will be able to pay off your mortgage.
Traditional wisdom holds that you should try to put down at least 10% of the value of the property as an initial deposit. So for example, if the house you are looking at is £200,000, then you should try to put down at least £20,000 for the initial deposit.
If a lender rejects your application for a mortgage, then it means they do not think you will be able to make your payments.
At this point, the best option is probably to lower your expectations and find more modest loan terms. It might be frustrating to truncate your expectations but it’s better than becoming financially overwhelmed.
How Much Can I Afford to Borrow?
There is no one size fits all answer to this question as everyone’s financial situation is different. That being said, here are some factors to look at to figure out how much you can afford to borrow.
In short, the more you put down for a deposit the lower your monthly mortgage payments will be and the faster you will pay off your loan. All other things being equal, a larger initial deposit is better than a smaller one.
Your outstanding debt includes debt from all kinds of lenders, including banks, credit cards, and individual debts. If you have a high debt to income ratio (~>30%) then it will be harder to find a mortgage.
This includes all of the money you make each month/year before taxes. Usually, the total amount you will be loaned depends on your income. Some banks will loan out to 5 times your salary but there are upper limits.
Lenders also look at how stable your income is. If you work freelance or just started a business, for example, you may only qualify from smaller mortgages.
Once you figure out the total amount of capital you have and how large of a mortgage you can secure, you can start figuring out exactly how much of your income to allocate to monthly payments.
The ’35 Rule’
A good rule of thumb here is the 35 rule—that is, you should allocate no more than 35% of your gross income to monthly mortgage payments. So if your gross pre-tax income per month is £4,000, then you should shoot for a monthly payment of around £1,400 per month.
If you are particularly scrupulous you could up this percentage to 45%. Whatever the amount you calculate, you should make sure it’s enough to cover if the interest rate fluctuates a bit.
The above recommendations are the traditional values, but if you want to be even more conservative with your finances, try to get that number down to 25%.
This might mean you have to put down an initial larger deposit but it will make it worth it in the long run. This is especially true if you take a more short term mortgage.
Again, there is no one size fits all solution here as the answer depends heavily on your unique situation.
In our opinion, a monthly percentage between 25%-35% or your monthly income should work for most people, though there is significant room for variance.
One important thing to remember here is: just because a bank approves a mortgage does not mean you can actually afford it. Make sure you do your due diligence when calculating your expenses and don’t take the first mortgage you can secure.