Mortgage approval does not always mean you can comfortably afford the house. The amount a lender says you can borrow and the amount you can comfortably spend on a home can be very different. Lenders mainly look at numbers such as income, debt, credit score and debt-to-income ratios when deciding how much they are willing to lend. But your personal budget also depends on your lifestyle, savings, future plans, spending habits and financial goals.
A lender may approve you for a specific loan amount based on its financial rules. But that number does not automatically mean you should spend that much on a home. A mortgage payment that looks manageable on paper could leave you with very little money for savings, retirement, emergencies or other expenses.
How much house can you afford?
Devon Hawkins, assistant teaching professor of economics at Elon University, said lender approval can create a “false sense of security” about affordability. Hawkins said lenders use statistical formulas, assumptions and averages, but they do not know a buyer’s lifestyle, future plans, financial discipline, non-negotiables or risk tolerance. Buyers therefore need to look beyond the approval amount and decide what monthly payment actually works for them, according to USA Today.
Professionals generally suggest spending no more than 30% of income on a mortgage, plus taxes and insurance. But income alone does not decide affordability because existing debt, savings and other costs also matter.
Buyers should include payments for student loans, car loans, credit cards and personal loans when calculating their budget. This is why looking only at your salary can give you an unrealistic idea of how much house you can afford.
How does a down payment affect your mortgage?
A down payment is the part of the home’s purchase price that you pay upfront at closing. That amount does not have to be financed through the mortgage, so you do not pay mortgage interest on it. A larger down payment means you borrow less money.
A smaller loan balance can lead to lower monthly mortgage payments. It can also reduce the total interest you pay over the life of the loan. On conventional loans, putting 20% or more down can also eliminate the need for private mortgage insurance, or PMI, reducing another housing cost, according to USA Today.
How does your credit score affect a mortgage?
Lenders look at your credit score to see how risky it is to give you a loan. Your credit score can affect whether you get a mortgage and what interest rate you pay. A higher credit score may help you get a lower interest rate.
A lower interest rate can mean a smaller monthly mortgage payment. It can also help you pay less interest over the full life of the loan. Even a small change in the interest rate can make a big difference over 30 years.
For example, on a $400,000 30-year mortgage, a 7% interest rate could mean monthly payments that are about $50 to $200 higher than payments at 6%, depending on other factors, according to USA Today. This means buyers should not look only at the home’s price. The interest rate also plays a major role in determining affordability.
The most common mortgage terms are 15 years and 30 years. A 15-year mortgage usually comes with higher monthly payments. However, borrowers generally pay less total interest because the loan is repaid faster. A 30-year mortgage usually has lower monthly payments. But borrowers pay interest for a longer period, making the loan more expensive over time. Buyers need to consider whether they want lower monthly payments or lower total interest costs.
What are the extra costs of buying a home?
Your mortgage payment is often more than just principal and interest. Many lenders use an escrow account to collect money for property taxes and homeowners insurance. These costs are then included in the buyer’s monthly payment. Property taxes and insurance can add hundreds of dollars to the monthly housing bill. This is one reason a mortgage payment that looks affordable at first can become much more expensive once all housing costs are included.
What is the 28/36 rule for mortgages?
One of the main tools lenders use is the debt-to-income ratio, or DTI. DTI compares your monthly debt payments with your gross monthly income before taxes. It helps lenders estimate whether you can handle a proposed mortgage payment while continuing to pay your other debts. Lenders use these ratios to set borrowing limits, but the numbers do not fully capture a buyer’s personal lifestyle or financial goals.
The 28/36 rule suggests spending no more than 28% of pre-tax monthly income on housing costs. It also suggests keeping total monthly debt payments below 36% of gross monthly income. For example, a household earning $6,000 a month would aim to keep housing costs below $1,680. Its total monthly debt payments would ideally stay below $2,160. The 28/36 rule is a guideline, not a strict rule, as noted by USA Today. Some lenders may allow borrowers to have a higher DTI ratio.
Using the 28% housing guideline, a household earning $50,000 a year would have a suggested housing budget of about $1,167 a month. That could correspond to an estimated home price of roughly $150,000 to $200,000 with a 30-year mortgage at 6.5% and a 10%-20% down payment.
At $75,000 in annual income, the suggested housing budget is about $1,750 a month, with an estimated home price range of $250,000 to $300,000. At $100,000 in annual income, the suggested housing budget is about $2,333 a month, with an estimated home price range of $325,000 to $400,000. At $150,000 in annual income, the suggested housing budget is about $3,500 a month, with an estimated home price range of $500,000 to $600,000, according to USA Today.
Personal affordability is the amount you can spend while still having enough money for your other priorities. That can include savings, retirement contributions, travel, family expenses, hobbies and unexpected costs. A buyer should therefore treat the lender’s approval as a borrowing limit, not necessarily a recommended home-buying budget.
What are the hidden costs of owning a home?
Buyers also need to plan for the upfront costs of purchasing a property. These can include the down payment and closing costs. Closing costs generally range from 3% to 6% of the financed amount. On a $200,000 loan, that could mean about $6,000 to $12,000 in closing costs. Buyers also need to plan for ongoing expenses after they move into the home.
Consider a buyer purchasing a $200,000 townhome with a monthly mortgage payment of $1,200. The buyer could also pay about $200 a month in property taxes. Homeowners insurance could add another $100. An HOA fee could add $150. Maintenance and utilities could add another $150. That would bring the total monthly housing cost to about $1,800, not $1,200. This shows why buyers need to calculate the full cost of owning a home instead of looking only at the mortgage payment, according to USA Today.
Why you should not spend your full mortgage approval
Just because a lender approves you for a certain mortgage does not mean you need to buy a home at that price. Even after calculating your maximum affordability, it can be smarter to leave some room in your budget. Having extra money available can help you deal with emergencies and continue saving after buying the home. It can also reduce the financial pressure that comes with a large monthly mortgage.
Spending nearly all of your available income on housing can make you house poor. This happens when you own a home but have very little money left for other needs. A high housing payment can reduce your ability to save. It can make unexpected expenses harder to handle. It can also increase financial stress. A major repair, job loss or other emergency could become much harder to manage if there is little money left after paying the mortgage.
How to calculate your home budget
Buyers should first determine their gross monthly income. They should also look at their net monthly income, or the amount they actually take home after taxes and other deductions. Next, calculate all monthly debt payments. This includes student loans, car loans, credit cards and personal loans. Knowing how much money is already committed each month gives buyers a clearer picture of what they can realistically spend on housing.
Why mortgage preapproval is not your budget
Getting preapproved can help a buyer understand how much a lender is willing to lend. But the preapproval amount should then be compared with the buyer’s own budget. If the lender approves more than the buyer feels comfortable spending, the buyer does not have to use the full amount. Personal comfort should remain an important part of the final decision.
