Owning your own home has been known to be one of the ultimate goals in life. Doing so suggests that you’re financially stable, a part of a community and ready to put down roots.
But very few Americans buy homes outright, particularly their first one. Instead, we take out a loan from a bank – which becomes our mortgage – to be paid back over years with interest tacked on.
Only if we pay off the entirety of the loan do we own the home and the land it sits on; otherwise, it remains the property of the bank.
When a consumer starts looking to buy a house, one of the first items on the agenda is getting pre-approved for a mortgage loan from a bank. Banks want a 360-degree view of your financial world before deciding whether or not to lend you money for a home purchase. Loan officers will ask for a battery of documents to determine your financial well-being including:
- Bank statements
- Credit card statements
- Retirement funds
- Investment portfolio
- Student loans
- Credit Score
- Car loans
- Total household income
- Tax history
All of these items will be factored into a decision on whether or not to loan you money, what amount of money to let you borrow, and what interest rate to assign to your mortgage. But how much house can you actually afford? Before we think about the future, we need to take a step back in time.
Avoid Repeating History
Depending on how old you are, you may or may not remember the Mortgage Crisis of 2007. Here’s a brief recap:
In the early 2000s, mortgage rates were lower, allowing homebuyers to get big loans with low monthly payments, even if they had bad credit or little documentation.
In 2006, home prices began to fall and as the economy stagnated, people who bought more home than they could afford stopped making payments on their mortgage. Mortgage rates rose on adjustable rate mortgages, and those homeowners saw their monthly mortgage payments skyrocket.
People defaulted on their home loans in record numbers, and banks began to fail. Investors saw their money in the real estate market vanish.
While it is now more difficult to qualify for a home loan than it was 15 years ago, banks are still looking to maximize their profitability.
The Worst Mistake Homebuyers Make
The big mistake people make when buying a home is to let the bank dictate how much money they should spend on a house.
Remember, the bank is not in the business of lending money to people to make friends. Loan officers have criteria they employ to maximize the profit the bank can make from each loan. The number banks assign to you as your loan amount is the maximum its algorithms assess you can pay back on a month-to-month basis based on your income.
That number takes into account your other financial commitments but doesn’t consider things like groceries, vacations, clothing, gasoline, medical emergencies, etc.
Ultimately, you need to take charge of this conversation with your lender to be sure you’ll be able to pay not just the mortgage, but all of your bills.
The 28/36 Rule
Most lenders determine how much they will approve on a home loan with a mathematical formula known as the 28/36 Rule. It is based on two income ratios that decide your maximum monthly payment. The “28” is also known as the front-end ratio and states that your mortgage payment, including insurance and taxes, should not exceed 28% of your pre-tax income for a month.
Therefore, if you make $5,000 a month before taxes, your payment should not exceed $1,400. The “36” is also known as the back-end ratio. It states that all of your debt payments combined for a month should not exceed 36% of your pre-tax income. It includes the mortgage, payments on car loans, credit cards, students loans, etc. In this case, with the same $5,000 pre-tax income per month, all your debt payments should be no more than $1,800. Under the bank’s way of thinking, you would qualify for a home loan of around $309,000.
Determining How Much House You Can Afford
Before you sign the dotted line to take out a loan for a house, get your personal finances in order. That means knowing what your assets and liabilities are, how much you are making each month, and how much you are spending each month.
Sometimes little expenses here and there can add up unexpectedly. It requires a deep dive into your statements to realize how much you’re really spending.
When mortgage lenders assess how much money you can afford to pay each month, they factor in only the minimum payment on your credit cards. The smart strategy to getting out of credit-card debt is to commit well beyond the minimum amount each month to knock down the principal and reduce the pain of the interest rates.
Let’s say you have a credit card with a balance of $5,000 and an interest rate of 12.0% and a minimum monthly payment of $150. If you only pay that minimum each month, you’ll wind up paying the credit-card company $7,361, and it will take 154 months – more than 12 years – to pay the balance in full. But if you commit to getting yourself out of debt and pay $500/month, you only spend a total of $5,548 and have the balance paid off in just shy of four years.
The 25% Rule
Despite the lender’s 28/36 Rule, a smarter decision is the 25% rule, which states that you should not spend any more than 25% of your monthly income on your mortgage, including insurance and taxes.
And even this rule should not be seen as a must. The lower your mortgage rate, the more money you have to spend on things like getting out of debt, savings for retirement/college, or improving other areas of your life.
So if your monthly pre-tax income is $5,000, you should not spend any more than $1,250 on rent. That equates to about $240,000 for your total loan amount, nearly $70,000 more than the bank approves. You can get a bigger, better house for that extra $70,000. But consider how many other things you could do with that money, and how much more stretched your monthly budget will be feeding an additional $550 into the mortgage company’s coffers 12 times a year.
Buying a house is an exciting process, but it requires consideration and restraint. Remember that the numbers given out by the bank are to maximize its profit from the loan. You should formulate your figures to determine how much house you can afford while still maintaining your other commitments and remaining financially sound.