You are in the market to buy a house. You have found a house that you really like. The price of the house is within your range. Now it comes down to determining if you can afford the monthly mortgage payment that includes principle, interest, real estate tax and insurance (homeowners insurance and private mortgage insurance, if applicable). These are called PITI. Let’s take a look at the….
15 / 20 / 25 Mortgage Plan
The interest you will pay over the 15 years is substantially lower than the interest you will pay for a 25-year or 30-year mortgage. Additionally, you will accumulate equity much faster with a 15-year mortgage since most of your early monthly mortgage payments are applied to interest … not principle.
20% Down Payment
You will start off having equity in your house if have at least a 20% down payment. You won’t be required to purchase private mortgage insurance (PMI). This will save you hundreds of dollars a year until the PMI is no longer required.
25% of Net Income to Mortgage Payment
There is one thing everyone needs to understand: mortgage lenders will allow you to bury yourself with mortgage debt.
As a rule of thumb, mortgage lenders will grant you a loan if the monthly PITI mortgage payment does not exceed 28% of your gross income.
I, and many other financial gurus including Dave Ramsey, believe that your PITI mortgage payment should not exceed 25% of your net after-tax income. If it does, you will not have the money necessary to maintain your house as needed. You will also have to think twice about going out for a special dinner with your spouse or friends, taking a nice vacation or buying a newer car.
Real Life Example
To start by making some assumptions to see if the potential buyer qualifies for a mortgage or can afford it within the 15 / 20 / 25 Mortgage Plan guidelines.
- $150,000 Purchase price of house
- $ 30,000 Down payment (20%)
- $ 80,000 Annual household gross (before taxes) income
- $ 64,000 Annual household net (after taxes) income or $5,333 monthly
- $ 3,000 Annual property tax
- $ 1,200 Annual cost of homeowners insurance
- 3.30% Mortgage interest rate on a 15-year mortgage
- 720+ Credit score
The first thing the assumptions illustrate is that the potential buyer is able to meet the 20% down payment objective.
The potential buyer has a history of being able to manage their money. This is documented by having enough money to make a 20% down payment and by having an excellent credit score. This indicates the potential buyer has the ability to pay for a 15-year mortgage that requires a higher monthly mortgage payment over a 30-year mortgage.
A mortgage loan in the amount of $64,000 at a 15-year fixed rate of 3.30% results in a total monthly mortgage payment of $1,196.12 or 22.4% of household monthly net income. The potential buyer qualifies for a mortgage. The 25% maximum monthly mortgage payment to monthly net income objective is met.
The potential buyer is nervously excited because he/she is close to being the new owner of the home they want and have been saving for.
Note on Calculating Net Income
There are special items that need to be deducted from gross income in calculating net income to arrive at an accurate and credible number.
- Self-employment tax for self-employed individuals
- Health insurance if individually purchased
- Any court-ordered alimony and/or child support obligations
The same 25% monthly payment-to-net income applies to renters as well.