Updated: Jan 2
Paying for everything with cash is a great life strategy. If you can save enough money to buy a home with cash then do that.
If, like the rest of us, you can’t pay cash because property values rise faster than you can set money aside, while inflation decreases your spending power and crushes your dreams, then you’ll need to buy a home the conventional way (pun intended for my finance nerds, aka nobody). This means going to a lender and getting a mortgage.
But There’s Something You Need to Know First!
Your lender is going to do some calculations in order to determine the monthly mortgage payment you can “afford” (which translates into the total loan amount you’ll be approved for). During this process buyers commonly assume that their bank can correctly determine what monthly payment is affordable. This assumption is utterly inaccurate and potentially disastrous for your finances.
The misconception is so ubiquitous that I feel it necessary to restate my point: your bank cannot accurately determine what home price is affordable for you!
There are a couple of reasons why you should not trust a lender’s calculation of affordability. First of all, the bank’s main objective is to make sure that you won’t default on (or stop paying back) your loan. They do this by taking a very limited snapshot of your income and comparing it to your debt obligations.This is, in essence, how they calculate what's known as your debt-to-income ratio (DTI).
Some lenders will approve a DTI of up to 50%, though anything above 36% is usually not advisable.
Image courtesy of visual.ly
The problem is that many people have other significant financial obligations that the lender does not consider- things like child care, out-of-pocket prescriptions/copays, or commuting costs. These expenses may make if difficult or impossible for you to cover the full mortgage payment.
Banks are historically bad at determining affordability, and sometimes completely disregard this factor. Remember the foreclosure crisis of 2008? Fun fact for those who didn’t watch The Big Short (and are confused by this article’s visual illustrations) - many of those same, shady lending practices are still happening en masse.
I recently received a phone call from a friend who was in the final stages of purchasing a home. He was very nervous about closing the deal. Why? Because he knew that he couldn’t actually afford to pay the mortgage without taking on a renter. Considering that lenders do not examine renter’s contributions, I was dumbfounded as to how he got the approval for this loan. Wanna guess what I advised him to do?
Moral of the Story
It is paramount to be clear about what you can afford before you talk to your lender. While the bank is mainly concerned with making sure you can cover your debts, your primary financial obligation (according your favorite Financial Consultant) is to make sure that your income covers all of your expenses, not just your debts.
You, and you alone, must make sure that your mortgage payment will not create a financial hardship that forces you to deplete your savings when you have to pay for home repairs, increase your credit card debt to cover your mortgage payment, or stop contributing to your retirement accounts.
How Do I Determine What I Can Afford?
As un-fun as creating a household budget is, it’s the most trustworthy method for determining affordability. At minimum, this means examining all of your expenses and comparing them to your income. Creating a budget will help you determine if there is room for your monthly housing cost to increase, and by exactly what dollar amount.
Once you’ve determined the maximum dollar amount you can afford to pay, be prepared to stand firm on that figure. Your lender may attempt to pressure you into something different. Keep in mind that your lender has incentives to get you into a bigger loan, but ultimately you will be the one making the payments and you have to do what is right for you!
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