It’s time to buy a new house. The bank tells you that you can afford a mortgage in this amount, and you are a little shocked. You didn’t think you could afford to buy that much house. But…if the bank says it’s all right, you must be better off financially than you think; so let’s buy that dream house and max out that mortgage amount, right? No! Wrong! Stop! Do not pass go, do not collect $200. The bank might tell you that you can afford to borrow that much, but you really cannot afford to borrow that much. In fact, this is why about half the people who lost their homes when the economy crashed in 2008 lost them – they bought much more house than they could afford thanks to ridiculous math.
There is no one size fits all motto when it comes to banks telling their customers how much house they can afford. There are a few industry standards, but it appears many lenders have their own way of figuring out precisely what it is that people can qualify to borrow. The biggest factor that many lenders take into consideration is your debt-to-income ratio.
Basically, they want to know how much you owe versus how much you make. Not all banks use the same formula, but we will discuss the basics without getting loan particular or specific. For the most part, the ideal DTI ratio is 36%. Lenders don’t want your monthly payments to exceed more than 36% of your income – including the payment on your new home. Some lenders want to know how much you owe total every single month, such as your phone bill, your insurance payments, your credit card payments and your student loan payments. Others only want the actual credit payments, and they don’t care about anything else.
We’re going to do some simple math right now to show you some examples of why the bank’s idea of what you can afford is not exactly what you can afford in real life – maybe it will help buyers understand how to approach their mortgage application when the bank mentions what they can afford versus what you can really afford.
Let’s say you make $75,000 per year. You have a $500 per month car payment, $500 in credit card bill payments and your other payments include things like your cable bill and cell phone and insurance are around $500 per month. That’s $1,500 per month you’re paying out just on things you have to pay for, and not even things like clothes or food or gas. Your gross bring home pay is $6,250 per month, but we all know you lose a significant portion of that paying for things like your taxes, social security and your retirement. Let’s say you actually bring home $4,800 per month after taxes and other items are deducted.
The bank doesn’t bother with net income – just gross. That means that you’re paying less than 36% of your DTI by paying $1,000 per month in expenses since we are going with the example that your bank only includes debts. You’re only utilizing 16%. This means the bank will allow you to apply for a mortgage that costs you no more than $1,250. If you have excellent credit and an interest rate of 3.5% on a traditional 30-year-mortgage with no down payment, your bank will tell you that you can afford to spend around $280,000 on a house to meet this monthly payment without issue.
Now, that sounds decent, right? You’re bringing home $4,800 per month and a $1,250 mortgage sounds totally doable. Let’s break it down now.
Mortgage – $1,250
Debt payments – $1,000
The bank has you at 36% of your income in debts. Now you’re bringing home $4,800 per month and spending only $2,250 on debts, leaving you with $2,550. That’s not bad, right? Well, you didn’t include your taxes and insurance into your escrow, which we are going to estimate at $3,500 per year together. That adds another $291 to your monthly payment to escrow. Oh, and did we mention you now have to pay Private Mortgage Insurance because you put nothing down? It’s usually between .5% and 1% of your loan value. If we assume you’re at 1%, that’s $2,800 per year broken down into your mortgage for another $233 per month.
You’re now up to $1,774 in terms of your mortgage payment with taxes, insurance and PMI since you financed 100%. Add your $500 in insurance and other small payments to that.
4,800 – 1,774 – 1,000 – 500 = 1,526
Now you still have to pay for groceries, utilities, water, maybe you have kids that go to daycare or play sports, you want to save money, too. You have $1,526 per month left over to pay for everything else in life you need from utilities to groceries to the kids to gas to shopping to fun to entertainment. That’s only $381 per week. Can you afford that? No.
The best decision is to put money down. Let’s rework this with a 30% down payment. That’s $84,000 – it’s a lot of money, I know. You’re now financing $196,000. That means your new monthly payment is $880 plus your taxes and insurance, which is an estimated $291. You don’t have to pay PMI since you financed less than 80% of the value of your home.
Now your monthly expenses look like this:
4,800 – 1,171 – 1,000 – 500 = $2,129
It’s better, but it’s still not that amazing. Let’s see what you could do if you lowered your budget. The bank says you can afford $280,000 worth of house. Let’s say you make the decision not to spend more than $200,000 on a house since you can get something really nice for that where you are. You’re going to put down 30% and finance $140,000. Your taxes and insurance are a little less. We’ll say they’re $1,800 now. That’s $150 per month.
Your mortgage payment will be $628.
4,800 – 628 – 150 – 1,000 – 500 = $2,524
Since you had more saved up for a down payment, let’s even say you’re able to pay off all those credit card payments and reduce your monthly bills by another $500. Now you’re spending a lot less and have $3,024 left over.
Now do you see why we encourage you to do the math as to what you can afford to buy rather than allowing the bank to do the math for you? So start with your budget, then use this mortgage calculator to plugin the real numbers that you know you can afford.
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