A mortgage represents a significant debt for individuals and is often the largest monthly payment the borrowers must make. When people refer to a mortgage debt being a percentage of monthly income, they refer to either gross or net monthly cash flow, based on all the other expenses the borrower must deal with. This is an important calculation both before the mortgage is created and afterward, when borrowers are making short and long-term financial plans.
Net vs. Gross Income
First borrowers should distinguish between net and gross income levels. Gross income is essentially income before taxes, as earned. When debt is compared to gross income, this is known as the front-end ratio, since it examines earnings at the very beginning, before other expenses are counted. Net income is generally income after taxes, or take-home pay after all taxes, insurance and retirement contributions have been paid. This is the income that the borrower can actually spend, which makes it more useful from a borrower's perspective. Both types of income are computed on the monthly level, since this is where most mortgage debt occurs.
Housing Expenses
Housing expenses refer to all expenses connected with owning and paying for a house (or paying for a rental). This is includes property taxes, homeowners insurance or mortgage insurance and all other expenses connected to the property in addition to the mortgage debt itself. In general, housing expenses should take up about 30 percent to 35 percent of net monthly income. Since the mortgage is only part of these expenses, it should take a little less, preferably between 25 percent and 30 percent. Some suggest allowing housing expenses up to 40 percent of monthly net income, but this can be dangerous for those with lower incomes.
Considering Food and Other Expenses
Needs vary from borrower to borrower. When computing the best percentage for housing expenses, homeowners should also carefully calculate expenses for food and transportation. Together the three expenses should not rise above 65 percent of net income and should fall well below that to make room for other necessary costs.
Lender Qualifications
Borrowers should note that when lenders compute debt to income ratios, they almost always use the gross monthly income figure. When considering gross amount, lenders tend to give mortgages that cover 25 percent to 28 percent of income. For Federal Housing Administration (FHA) loans, the figure is set at 29 percent of gross income. When all other debts are added in, lenders want to see a total debt figure of 33 percent to 36 percent of gross monthly income.
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