How much should your mortgage be? One school of thought says it should be as much as possible. I belong to the other school of thought. There is a proven formula for housing costs. I recommend following the formula.
The formula helps you keep your housing costs in line with your salary and with a typical lifestyle balance. The key to financial decisions is keeping a balance while living within your means.
How much should your mortgage be? Work backwards
The IRS recommends spending no more than 30 percent of your pre-tax income on housing. Therefore you should pay 30 percent of your income, or less, on your monthly mortgage payment. Keep in mind that includes interest and escrow. So leave yourself a little bit of room.
So if you make $50,000 a year, you should be spending no more than $1,250 a month on your house payment. Keep in mind that rising interest rates mean everyone will be buying a little less house year over year. Interest rates have been historically low for more than a decade now, and that won’t last forever.
Banks will generally loan you 2-5 times your annual salary, depending on other factors. So let’s start at the midpoint of 3x your salary. If you make $50,000, work backwards from $150,000. Use a mortgage calculator to figure out what the monthly payment would be on a $150,000 loan at the prevailing interest rate. Leave at least a couple hundred dollars in margin for your escrow payment, which covers insurance and property tax.
A quick Google search showed that at this writing, a typical mortgage rate is 4.8 percent. Punching that into an interest rate calculator, $150,000 at 4.8 percent interest works out to $787 a month. Even factoring in $200 a month for escrow, that’s well below $1,250 a month. Bumping it up to $195,000 at 4.8 percent interest yields a monthly payment of $1,023 a month. So as long as interest rates stay below five percent, a $50K salary might be able to swing a $195,000 mortgage.
As a landlord, I have firsthand experience with this. I won’t approve a tenant whose income doesn’t meet the IRS’ 30-percent rule, but I can’t control what happens after they move in. When my tenants get their hours cut, or something else happens to knock them below that threshold, they have trouble paying their rent. This guideline works.
Don’t play games with gimmicky loan types
Your bank may try to talk you into getting an adjustable rate mortgage, an interest-only loan, or another gimmicky loan type to lower your rate. Don’t fall for it. Get a conventional, traditional 30-year mortgage, or better yet, if you can afford a higher payment, a 15-year mortgage. Make the 20 percent downpayment the bank requires to avoid PMI as well.
The financial structure of a 30-year mortgage and a 20 percent downpayment has existed for generations because it works. Not following those rules was one of the main causes of the 2008 financial crisis.
Regardless of what the bank will let you do, try to follow the time-tested rules for yourself. Although it’s human nature for all of us to think we’re exceptional, in reality most of us are not. Assuming that you are typical, not exceptional, is one of the keys to successful personal finance. William Nickerson, the author of the first really popular series of books on real estate investing, considered himself average, even when he had more than $6 million in wealth. Not considering himself exceptional, even when he reached a point where any reasonable person would say he was exceptional, as one of his keys to financial success.
When to bend the rules and go beyond 30 percent
I didn’t exactly follow the 30 percent rule myself when I bought my house. For one thing, I hadn’t heard that rule when I bought it. I had just gotten promoted and expected a raise, so I figured my income would grow into the house within a year or two. I looked at a lot of houses, and most of the houses that fell below my 30 percent threshold were just fine for me to live in, and would have been fine when I got married, but weren’t big enough to raise a family in.
Then I found the one. I found a house that wasn’t too big for me to live in alone, would be big enough to raise a family in, and not too big once the kids moved out on their own. It wasn’t necessarily perfect for every stage of life, but it would be really good at any stage. I moved around a lot as a kid, so finding a place and never moving again really appealed to me.
Moving is expensive. So I decided to buy the house instead of upgrading to it, or one like it, a few years later.
My career path didn’t exactly take the path I expected it to take, but the bet paid off. I paid the mortgage off early and haven’t needed to move. I had to eat out less and drive the same car a lot longer than most people would, but making those sacrifices early on saved me a lot of money in the long run.
So you can ignore the IRS if you wish, as long as you’re willing to make cuts elsewhere in your lifestyle in order to afford it. Many people will be reluctant to do that, however, so the 30-percent guideline works well for the lifestyle balance most Americans want to lead.
But how much should your mortgage be if you want to live a lifestyle whose balance is pretty normal? Stick with that 30-percent rule and you’ll do fine.