We love helping clients find their dream homes, but we never want them to fall into the trap of buying more than they can actually afford. While lending standards are designed to protect you (and the bank’s investment), many people qualify for a mortgage that is really more monthly expense than they can handle.
When people are buying a new home, they are usually focused on location, square footage, and number of bedrooms, and often leave the financial side to their loan officer to figure out. Homeowners do need to be thinking about how much mortgage they can truly afford. Considering that 76 million Americans are struggling financially and describe themselves as, “barely getting by” and “living paycheck to paycheck”, a major investment like a home can push people over the edge into financial crisis. We don’t want to happen to you, so consider this advice:
Most financial planners recommend keeping the amount you spend on housing to 25% of your monthly budget. However, the Bureau of Labor Statistics reports that the average American couple spends over 31% of their budget on housing, and single people send nearly 36%. Bankrate reports that more than 80% of current homeowners say their monthly mortgage payment is the primary reason they cannot save as much money as they would like, and parents especially have a hard time reaching their financial goals amidst the cost demands of children’s needs and activities.
A very straightforward way to keep your mortgage in check is to follow the 25% Rule. Including maintenance, keep your housing payments to 25% of your household budget. Conversely, most banks use the debt-to-income (DTI) ratio to determine what you can afford, and this limit is much higher. Yes, your home is an investment in the future, and real estate has been proven to be a good one. However, the market is always fluctuating, and you cannot guarantee your return or its timeframe. Having too much of your net worth (assets) tied up in your home is a risky proposition.
The down payment you put toward your home purchase plays a key role in what you can afford, your monthly mortgage payment, and the amount of equity you establish in your home purchase at the outset.
Ideally, having 20% in hand to put toward the purchase price is the best idea. With this amount, you are not only reducing your monthly payments and establishing decent equity right away, but you can avoid being required to pay mortgage insurance.
When your down payment is less than 20%, your costs rise. Your lender will likely require you to pay for private mortgage insurance, which averages close to 1% of the total loan amount. You will pay this as part of your mortgage payments until you have built up 20% equity in the home. It might not sound like a lot, but on a $240,000 home, that is $200 per month, a significant amount that could otherwise be going toward an emergency fund and savings.
Every loan that is originated with a traditional lender involves closing costs. These costs cover loan origination and other processing fees, as well as other costs involved in the transfer of title and ownership. Amounting to several thousand dollars, if these costs are worked into the amount of your mortgage loan, your monthly payment just went up. Further, for closing costs to be worthwhile, you need to stay in the loan and/or the home for at least five years.
The cost of homeownership doesn’t stop at your monthly mortgage payment. While many mortgage products roll in Property Taxes and Homeowner’s Insurance, some don’t require it. Additionally, Association Fees and other expenses need to be budgeted for.
Keep in mind all the other costs associated with homeownership: insurances, utilities, maintenance, and upkeep. If you are moving further away from your job, you will have associated commuting expenses, and your children’s educational requirements may involve higher costs. Routine maintenance and upkeep need to be planned for, and the surprise need for a new refrigerator might demand quick cash. Generally, budgeting 1% of the total cost of the home covers annual upkeep, not including big-ticket items such as a new roof or heating system.
All the expenses associated with home ownership should be estimated before you determine a monthly mortgage payment that will work for you.
Taking on a larger financial burden than you can afford has wide-ranging consequences. We all like to think the worst won’t happen, but the reality is that people get sick, life circumstances change, and jobs can be lost. We all know we should have an emergency fund, yet half of Americans say they would be hard-pressed to handle an unexpected $500 bill. If you keep your home, and the monthly mortgage payment, affordable in the first place, you will be in better shape to handle what life throws at you. When your mortgage doesn’t drain you every month, you can also keep up with your other bills and avoid excess credit debt, leaving more money in the bank and savings for the future.
Beyond the weekly and monthly financial demands, taking on larger payments than you can handle significantly impacts your life long-term. Your savings will suffer, and other financial goals such as saving for your children’s education or your retirement will take a backseat. When these needs catch up to you, you will be left unprepared. Being clear on your overall financial priorities, planning for the unexpected, and setting savings goals are important factors to consider as you think about a new mortgage.