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Financing

The Mortgage Balancing Act: What You Spend vs. What You Make

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Smart income choices play an important role when buying a home -- it's not necessarily all about what you earn, but how you spend it too.

Income is a crucial component lenders consider when granting you a mortgage. It is the basis by which they are going to get repaid, because a mortgage loan is not really a loan against the property -- it is loan against your ability to repay. The dwelling is simply used as collateral in the event you default on the mortgage.

A low interest rate and affordable monthly payment helps keep the cost of your new house down, and a good credit score can help you secure those. (You can see where you stand by reviewing two of your free credit scores each month on Credit.com.) But income is a vital part of getting approved and then keeping your mortgage affordable throughout the repayment period.

How debt & income affect your mortgage

Income and debt are yin and yang, opposites of each other. Debt is a liability, whereas the more income you have, the more power you have to make those liabilities go away. Having more income also gives more control of the following.

  • It allows you to prepay your mortgage faster.
  • It allows you to qualify for more house when buying a home.
  • It allows you to move into a shorter and more aggressive debt pay-down structure such as a 15-year fixed-rate mortgage.
  • It allows you to pay off your credit cards in full every month, rather than paying unnecessary and pricey interest (assuming you're making smart financial choices).
  • It allows you to consume smart debt, such as purchasing a rental property that can generate even more income.
  • It allows you to make investments, generating more income.
  • It allows you to save and plan for the future.

 

Having this control over these and other financial choices is precisely why it is prudent to carry a debt-to-income ratio no bigger than 36% of your gross monthly income. While your lender might allow you to qualify for a larger mortgage to pay for a bigger house, it's in your best interest to try to exercise some restraint. Just because you can afford a $3,500 monthly mortgage payment or an $800 monthly car payment doesn't necessarily mean you should take one on.

The goal when borrowing mortgage money is to put yourself in a position where you can have a life beyond paying it off, while still saving and contributing to the retirement bucket. Mortgaging your income by taking on new debt or not reducing the cost of high debt already in place limits your future ability to borrow or save.

What you need to consider before you buy

Mortgage tip: Always remember it takes $2 of income to offset every $1 of debt for a 2:1 ratio for mortgage qualifying purposes.

If you want that fancy Tesla at an $800 per month, then you'll need $19,200 a year in extra income or you'll need to cut a current debt payment of $800 to balance your debt-to-income ratio.

If you want the dream house at $3,500 month, then aim your debt-to-income ratio at 36% -- meaning you would ideally want income at $117,000 a year without carrying other consumer obligations in order to afford this mortgage.

Exceptions to the debt-to-income ratio rule?

There are however, a few justifiable exceptions that make exceeding this 36% debt allowance reasonable. These include the following.

  • You know your household income is poised to go up in the near future
  • You will be able to cut another expense in the short term, such as paying off in full or refinancing another obligation.
  • Your mortgage payment will drop (perhaps via refinancing) in the near future.
  • You are coming into cash soon, with which you plan to make smart choices.

 

When you are thinking about buying a home or refinancing a home you already own, today's borrowing choices should be based upon what the future holds, not just what's right here in the now. By focusing on what the future holds and keeping your income as high as possible in relationship to your liabilities, you will position yourself to have an easier time qualifying for a mortgage and giving yourself for a brighter future financially.

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This article was written by Scott Sheldon and originally published on Credit.com.

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