When shopping for a new home, it’s important that you buy a house that meets your needs without taking away from your quality of life. Â If you borrow the maximum amount the banks will lend you, you could end up house poor in the home of your dreams with little else. Remember, it’s in the best interests of your real estate agent and lender to see you spend as much as you can on a new home, as they profit from it in the end. The more house you buy, the higher your expenses, so keep all of the costs in mind before you sign on the dotted line.
How Much Loan Can I Afford?
Though there is a lot of information that lenders look at when qualifying you for a mortgage, the debt-to-income ratio (DTI) tells them how much you may be able to borrow. To calculate your front-end DTI, add up your mortgage payment, HOA fees, property taxes and insurance and divide it by your gross monthly income. Get your back-end DTI by adding fixed payments, such as student loans, car loans or alimony payments, to your monthly housing expense and then divide it by your gross monthly income.
For conventional loans, lenders look for a front-end ratio no higher than 28 percent and a back-end ratio no higher than 36 percent. If you have a lot of assets or cash reserves and a very high credit score, they will often allow a back-end DTI of up to 45 percent. FHA DTI limits are 31/43 and USDA limits are 29/41. VA loans don’t distinguish between the front end and back end and allow a DTI of up to 41 percent.
If you live in California, which has a state income tax, and you make $100,000 per year, the conventional DTI limits would allow you to have a housing expense of $2,333 per month and overall debt of $3,000 per month. Depending on the cost of your property taxes and insurance, you would be able to qualify for a 30-year fixed-rate mortgage of roughly $350,000 at 4.5 percent interest. However, once federal and state taxes are taken out of your paycheck, you’d be left with $2,637 each month after your housing and recurring debts are paid. If the lender allowed you to have a back-end DTI of 45 percent, you would be left with $1,887.
Why Shouldn’t I Borrow as Much as I’m Allowed?
It may surprise you to discover that roughly 76 percent of Americans live from paycheck to paycheck, and most of them have very little, if any, emergency savings on hand. This plays out quite often because people tie up too much of their cash flow in their house, leaving them little left over after all of the bills are paid to put any away.
Let’s use the same example of a California resident who makes $100,000 per year. If he is allowed a DTI of 45 percent and he borrows the maximum of $350,000 through a 30-year fixed-rate mortgage at 4.5 percent, his monthly mortgage payment would be $1,773. Add in insurance and average property taxes, and that brings the total to roughly $2,300. Since his net monthly income is $5,637.88, he would have $$3,337.88 left over for other expenses.
Adding up the average cost of food, utilities, clothing, healthcare and transportation for a family of two totals roughly $2,766 per month, leaving our California homeowner with just over $570 each month to spend on savings, maintenance, repairs and other expenses that might come along. This scenario doesn’t take into account child support, alimony or student loan payments, and it assumes that the homeowner isn’t paying private mortgage insurance (PMI) or mortgage insurance premiums (MIP) on top of their mortgage payment. If the homeowner went with a more affordable home that cost $250,000, his mortgage payment would be significantly lower at $1,680, leaving him with almost $1,200 each month after all of the bills have been paid.
Buying the least expensive house makes sense for most people. When you have a decent monthly cash flow, you have the option to put more money away in savings or invest it hoping for a good ROI. Since you have a relatively low mortgage, you may bankroll enough to pay off the mortgage early, leaving you with an ever better cash flow going forward. Having a good amount of money saved is also important in case there’s a financial crisis, such as losing your job.
What Are the Pros to Buying Big?
Buying more than you need right now is the right choice for some people. Young couples who are just starting a family and who plan to stay in the home for many years are probably best off by buying what they need for now and into the future. Young couples also have fairly new careers, and they’re more likely to be making a significantly higher income over the long term.
Just because you qualify for a large mortgage doesn’t mean you should take it. Being able to make the monthly payments is only one piece of the puzzle. If you’re not saving a decent percentage of your income for the future or your day-to-day quality of life is impacted because you don’t have any extra money, then you’ve probably bought more house than you really can afford. Before you fall prey to the allure of a big mortgage, make sure you take all of your expenses into consideration so that you don’t end up house poor.
2 Point Highlight
Buying more than you need right now is the right choice for some people.
When shopping for a new home, it’s important that you buy a house that meets your needs without taking away from your quality of life.
