When prospective homeowners start the process of shopping around for a mortgage, they’re typically concerned with getting approved – and not much else.
While it can feel great to be approved for a large mortgage, homebuyers need also to ask if they should enter into that agreement. While lenders won’t let you sign on a mortgage they don’t think you can pay back, they absolutely will let you – and even encourage you – to take out the largest mortgage you can afford.
Rather than consigning yourself to years of hefty payments and an air-tight budget, consider taking out the mortgage you can afford rather than the biggest your lender offers. Read on for what you should take into account, and how to estimate your ideal housing budget.
How Much the Lender Wants You to Spend
Financial planner and President of NextGen Wealth Clint Haynes said lenders want to see a monthly housing cost that’s 28% or less of your gross monthly income. Your housing cost includes your mortgage payment, property taxes, homeowner’s insurance and private mortgage insurance, which can be avoided if you put up a 20% down payment.
Haynes also said that lenders want to keep all total debt payments to 36% or less of your gross monthly budget. This includes your mortgage and any other debt you have such as auto and student loans and credit card debt.
However, you can also choose to spend less than what the lender is willing to give you.
“Your focus should be on what you can afford,” Haynes said. “I want to see my clients keep their housing cost ratio below 20% and their total debt ratio below 28%.”
How Much You Should Spend
A basic rule of thumb for determining your housing budget is to spend 25% or less of your take-home pay on housing. Even though this may seem like a small percentage, that number helps you pay for your home while being able to afford other bills.
Those who have a mortgage with a high monthly cost may struggle to make payments on time if they lose their job, their other expenses increase, or they face a sudden life change like having a new baby or becoming disabled.
Remember – lenders want to lend you as much as they think you can comfortably afford, but they don’t know your budget and your other financial goals. Following the path a lender lays out could lead to an uncomfortably tight budget and unnecessary financial anxiety.
For example, if you want to quit your job and start your own business, having a high mortgage could delay that goal. If you want to retire early and save 30% of your take-home pay in your 401k, that may be impossible with a large mortgage.
Those in two-person households, especially those with kids, should also take into account any future plans to downgrade to one income. This could include a situation where one partner becomes a stay-at-home parent or goes back to school, or something as simple as a sabbatical.
These rules are arbitrary and not necessarily the right answer for everyone. For example, CFP Joseph Carbone, Jr. of Focus Planning Group said those in expensive housing markets might find it impossible to stick to the 25% guideline.
“I advise my clients who are in this situation to maybe cut back on the expensive car and purchase a cheaper car with lower monthly payments or purchase a car outright and have no payment,” he said.
One way to gauge your readiness is to start making those mortgage payments before you actually purchase a home. You can set aside that money in a savings account for a few months and see if you feel comfortable living on that budget.