Buying a home is a big investment. But how big? A lot of factors go into deciding how much your mortgage should be, but often banks and calculators will give you a high estimate. No one wants to be house poor, however, so 20/20 Mortgage Life Insurance is going to break down some of those numbers so you can make smart decisions for yourself.
Rule Of Thumb
Mortgage lenders have a “rule of thumb” for determining your loan eligibility. The 28/36 rule says that your mortgage (plus debts like escrow or insurance) should be equal to or less than 28% or your gross monthly income (this means pre-tax) and that your total debt load including home expenses should be equal or less than 36%. This jives with the Statistics Canada findings that most homeowners spend around 28% on their homes.
Budget Breakdown
28% = Housing Debts (includes mortgage, escrow and mortgage insurance)
+ 8% = Other Debt (includes all Housing Debts plus car payments, student loans, consumer debt, child support and alimony)
= 36% TOTAL DEBT
One important thing to remember is that your numbers can be less than those percentages. Living below your means can open up a higher quality of life in other ways, like being able to afford a bigger or safer car, travel, more savings for education funds, getting mortgage life insurance, and securing your family.
Debt
Let’s be honest: this is the biggest factor in your mortgage loan eligibility after your total income. It won’t matter if you’re making six figures if you have a debt load in the thousands of dollars every month. 36% of your total gross income sounds like a lot of wiggle room, but it’s only 8% higher than your mortgage and home expenses. That doesn’t leave much room for any other kind of debt. If you have high student loan payments, credit card debt, alimony and/or child support, it adds up quickly and you will need to purchase less home to accommodate those numbers into a healthy budget. When you are using online calculators, it is a good idea to round up on your debt load and round down on your income.
Paying down debts as fast as possible could tip the scale in favor of your getting a mortgage, in addition to opting for a smaller mortgage.
Reality
It’s easy to look at the math and say, “I make $5,000 a month before taxes, and 28% of that is $1,400--that’s a great mortgage!” But you have to remember that that $1400 includes any private mortgage insurance you’re required to hold (if your down payment is less than 20% of the home price), and truthfully should include other home expenses like your property tax and even utilities or homeowner’s association fees to allow a larger amount of debt in the remaining 8% of total debt under the 28/36 rule.
Some financial experts even suggest adding up to 40% to the mortgage to allow for hidden homeowner’s expenses--extra utilities like sewer, that private mortgage insurance and condo fees, or repairs you’ll need to do yourself--and don’t forget all the fees that come with the home buying process, including closing costs. Suddenly that $1400 isn’t extending nearly so far, if you want a sound budget. While banks use the 28/36 rule, here's a slightly more detailed equation to try:
(Monthy After-Tax Earning - Monthly Total Debts) x 25% = Maximum Monthly Mortgage Payment
Clearing Up The Confusion
Part of the confusion lies in how different institutions calculate these numbers--do utilities get included in the mortgage part of the debt or the extended part of the debt? What about homeowner’s associations or condo fees? The trick is to account for all these variables when deciding how much house to look at. If you can in theory afford $1400 a month toward housing, but you currently have your utilities included in your rent and don’t pay a condo fee, you’re going to need a smaller mortgage to factor those numbers in. If you have credit card debt or student loan debt, you may want to ensure that all the fees related to home-owning expenses are included in that 28% so that you have all of the 8% leftover for those expenses. Otherwise you risk carrying too high a debt load for lenders to risk loaning you the mortgage you want.
So let’s do some math.
Say you bring home $4200 a month after taxes. You have some student loan debt, paying $200 a month toward it. Using the more conservative rule of thumb, 25% of the remaining $4000 is $1000. Let’s say you don’t have any homeowner’s or condo fees expected, but your down payment will be less than 20%, requiring private mortgage insurance. You’ll want the private mortgage insurance included in your mortgage, and the total payment to be $1000/month or less. That may or may not sound like much, depending on where you live, but the important takeaways remain the same.
Summary
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Your total debt load should be less than 36% of your income, including your mortgage and associated expenses.
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Account for all hidden fees like private mortgage insurance utilities, taxes, condo fees, homeowner responsibilities like repairs, and closing costs when calculating your mortgage. Don’t forget mortgage life insurance!
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Decide how much home you really need. If you can make do with less, you won’t risk becoming house-poor. Be honest: this decision will affect your financial stability for the next 30 years of your life.
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Always consult a financial professional, but remember that a bank will try to sell you the highest mortgage possible to get higher interest payments. It’s okay to tell them you won’t pay more than $X, or that you want your debt load to be under Y%.
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Try the mortgage calculator from the Canada Mortgage and Housing Corporation. The numbers will be different from our rules of thumb here because it incomporates interest and amortization. Mortgage rates typically vary between 2.5-6%, so we recommend averaging 4% and using a 25 year amortization.
Contact Us
One of the expenses that could be rolled into your mortgage payment with your private mortgage insurance is a mortgage life insurance policy, if you purchase through a bank. We don’t recommend that for a variety of reasons (find out why 20/20 Mortgage Life Insurance is better), but you may wish to incorporate your life insurance policy premium into the smaller percentage of the debt load (Housing Debts, above). 20/20 Mortgage Life Insurance has a variety of products and can save you up to 25% over bank-issued mortgage life insurance. It’s a factor to consider when you’re buying a home. For more information, contact us using our easy online form.
