Before applying for a mortgage, how to know if the house you want is truly affordable. Because buying a house you can’t afford is like buying a one-way ticket to financial trouble. Follow the 28/36 rule and other house affordability tips. Plus, how to save tens of thousands by snagging the best interest rates.
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Before Applying for a Mortgage
Before applying for a mortgage, realize that your life is not being played with Monopoly money, but with real dollars. And that means that buying a house you can’t afford is like buying a one-way ticket to financial ruin. Only it lasts a lot longer than two hours!
You’ve probably known someone who was so house-poor that they couldn’t do any real living. We made that mistake once. It was miserable. We couldn’t walk out the door without being worried about spending money on gas to go to a free park! Trust me… it wasn’t a pleasant way to live. And it led to many money arguments.
You can spare yourself considerable personal agony by running these numbers before applying for a mortgage and adjusting your purchase plan if necessary.
Could You Survive a Crisis with Your Mortgage?
The financial crisis of 2008-2009 saw an unprecedented crash in housing prices along with huge job losses. It hit our area earlier and lasted longer than the rest of the country. Foreclosures were a dime a dozen. The people who survived the layoffs and didn’t end up in foreclosure were those who had their houses paid off and a cushion of cash to weather the storm.
I ran into a friend months into the crisis and asked how their family was faring, knowing that she lived in an upscale subdivision with record numbers of foreclosures. She told me her husband had lost his job, but that they’d fast-tracked paying off their house so it was paid off. And she’d taken a part-time job to stay afloat. Most neighbors in their neighborhood were either “under water” (meaning you owe more than you could sell it for) or in foreclosure (meaning they couldn’t pay so the bank comes and claims the property).
There are many steps to buying a house and applying for a mortgage. But the first step and arguably the most important is to find out how much you can afford. So how much house can you really afford today? Lenders are incentivized to write as large a mortgage as possible. So don’t be conned. Run these numbers personally before applying for a mortgage.
How Much House Can I Afford? Follow the 28/36% Rule.
How much house can you afford on, say, a $100K salary? That depends. Most financial advisors say you shouldn’t spend over 28% of your gross monthly income on housing expenses, and no more than 36% for all household debt combined. All debts combined include your mortgage, interest, taxes and insurance, plus student loans, car payments, credit card payments, and any other loans you might have.
$100K salary a year is $8,333 per month so theoretically you can afford to spend $2,333 per month on your mortgage payment including insurance and taxes. If you have no other debts you could theoretically stretch that to 36% ($3,000 per month). But be careful… 36% is a hefty amount to spend on housing and makes all your other margins thinner. Lower your stress levels by keeping with the 28% principle.
Realize also, that any declines on your credit record can ding your credit score for up to six months or so. This suggests you should run your own numbers before applying for a mortgage to be sure you fall inside the affordability parameters for the home you want.
Stick with This Tried-and-True Home Buyer Formula
This 28/36% formula is the tried-and-true guideline for home affordability. You’re going out on thin ice if you exceed this. What’s more, depending on where you live, this could either be a fair guideline or it could fall completely flat. Homeowners’ insurance cost and taxes can vary wildly between areas… as can the cost of food, gasoline, eating out, and a slew of other expenses you have to cover with those same earned dollars.
We just relocated from a state where our homeowners’ insurance cost $900 per year, to where it costs $3400 a year – for a home of exactly the same value. This instantly raised our housing expenses by over $200 per month. Especially if you live in a high cost-of-living area, err on the side of caution by taking out a lower mortgage – even if a lender is willing to offer you more money.
Another Key Calculation: Your Debt-to-Income Ratio
Another way lenders calculate whether you can afford a house when you’re applying for a mortgage is with what’s called your debt-to-income ratio, or DTI.
DTI compares your total monthly obligations (including your house payment, insurance and taxes, plus all other loans) to your monthly pre-tax income. If you have high debt relative to your income, you have a higher DTI. This number reveals your bandwidth to assume additional debt. The higher your DTI, the less likely you are to get a mortgage – let alone a mortgage at a decent interest rate.
Most lenders won’t approve you for a mortgage with a DTI above 43%. The good news is that monthly expenses like gym memberships, utilities, and health insurance are generally not factored into your DTI. Just your debts.
To lower your DTI and improve your chances of getting a mortgage, pay off as much debt as possible. You’ll be more impressive to lenders, better able to handle monthly bills, and better prepared for an emergency.
How to Calculate Your Own DTI before Applying for a Mortgage
Pull out your smartphone calculator. Now:
- Add up your monthly rent/mortgage plus all debt payments (student loans, car loans, credit card payments). Let’s assume $1200 rent + $200 car loan + $150 student debt + $85 credit card payment = $1635.
- Divide that $1635 by your gross monthly income… let’s say it’s $4,000. Your DTI (rounded up) is 41%.
- Now what if you paid off your credit card and got rid of that $85 payment? Your DTI drops to 39%. Boom! You’re already better qualified.
Yet Another Mortgage Affordability Factor – Your LTV
LTV, or loan-to-value ratio, is important to lenders when applying for a mortgage. It reflects the amount of the loan compared to the total home value. And consequently, the amount of risk the lender assumes. Bigger down payments often mean better interest rates because it reduces the lender’s stake in the transaction.
If you don’t have a large down payment saved up now but you’re ready to buy, consider refinancing later if interest rates drop in your favor and closing costs won’t eat you alive. In the meantime, you’ll want to get your finances and credit score in excellent shape.
Snagging the Best Interest Rate when Applying for a Mortgage
A lower interest rate can save you tens of thousands of dollars over the course of your loan’s life. That’s why it makes sense to snag the lowest possible rate when applying for a mortgage. How do you get a lower rate? Lenders will consider these factors:
1. High credit scores.
Borrowers with FICO scores in the 800 range (plus or minus) are in the best position for the most competitive rates. We talked about how to boost your FICO score here.
2. Lower debt loads.
Pay off your debt obligations – student loans, car loans, and credit card debts. It helps more than you might think.
When I sold real estate, I took some prospective buyers home-shopping. They both worked, and had a pre-approval letter. Yet they were declined for a mortgage because of $100,000+ in medical school debt. And they desperately wanted a house! Declines hit your credit score hard. Just like the actual debt does.
3. Bigger down payment.
The bigger down payment, the better, in a lender’s eyes. Lenders are by nature risk-averse. So, the bigger down payment you can legally and ethically scrape together, the better, when applying for a mortgage. At which point they’ll reward you with a lower interest rate.
But don’t leave it all to lenders. They don’t know you like you know you. They don’t have insight into your other dreams besides buying this property. What’s more, your credit can take a big hit if you apply and get declined for a mortgage. It only makes sense to avoid that snag.
Run your own calculations, check your credit score, pay down debt, and consider your other goals and aspirations. Combined, they’ll help you understand how taking on mortgage debt will affect your life. And whether you’re ready to at this point in your life.
Adding All These Factors Together…
Putting it all together, address these factors to get your best deal when applying for a mortgage – or to make your best case for affording the home you dream of buying.
1. Maximize Income.
Defined as money you earn or receive on a regular basis, like salary, investment income, and side hustle income. This forms the baseline for what you can afford each month.
2. Maximize your down payment.
The bank sees it as cash reserves. It’s the funds you have available for a down payment and closing costs.
3. Reduce debts and obligations.
This means paying down credit cards, student debt, and auto loans. You’d also be wise to factor in other personal monthly obligations that a lender might not consider – charitable giving and home maintenance, for example.
4. Maximize your credit score.
Your credit score is a snapshot of your willingness and ability to pay back your obligations… at a particular point in time. You can improve your credit score by making all payments regularly and on time, and pay down your debts.
When banks underwrite you for a mortgage, they consider only your outstanding debts as of today. They don’t factor in that you might want to set aside $400/month for your retirement account, or want to buy a new car or start a family next year.
It’s also a smart idea (even if your lender doesn’t outright require it) to create a 6-month emergency fund. You never know when your house will throw an emergency at you. Or life in general. Be ready for it.
The Bottom Line… Calculate for Yourself
Long story short, your bank or mortgage lender will do a lot of the heavy lifting in determining home affordability. Use their tried-and-true guidelines before applying for a mortgage. Run your own numbers. So you know the state of your own finances. You’ll be glad you did.