Are You Living Above Your Means? Mortgage Affordability 101
So, you’re ready to become a homeowner, but you’re wondering how much house you can afford. When you apply for a mortgage loan, your lender will look at a few factors to determine how much you qualify for.
What factors will your lender consider?
Credit score
Your credit history, which is summed up in your credit score, shows a lender your ability to repay your debts. Your credit score is calculated using information from your payment history, outstanding balances, length of credit history, number of credit inquiries, and type of credit history (student loans, credit cards, etc.). Your score will be a number ranging between 350, which is poor credit, and 850, which is excellent credit.
Once a year, you can check your own credit score for free from each of the three credit reporting agencies: Equifax, Experian, and TransUnion. If you’re unsure whether your credit score is high enough to qualify for a loan, take the opportunity every year to check your score and work on improving your credit if it’s not where you want it to be.
Income and debt
Your mortgage lender also will look at your income, specifically, your debt-to-income ratio (DTI). Your DTI is calculated by dividing your current debt, including car and student loans, credit card debt, etc., by your gross income, which is your income before taxes. When you multiply this number by 100, you get your DTI. Most lenders are looking for a DTI of 43% or lower.
Dpwn payment funds
Additionally, a lender will look at how much you have saved for a down payment. For a conventional mortgage loan, a 20% down payment is standard if you want to avoid paying private mortgage insurance, but some loan products offer low and no down payment options.
A lender will consider your savings accounts, and also any other assets you may have, like investment accounts. These are important to them, not only for a down payment, but also for your ability to repay if you happen to lose your source of income or become unable to make mortgage payments for some other reason.
It’s important to understand the parts of your financial profile and what your lender is looking for when you’re getting a mortgage loan. The factors we just talked about determine how much loan you qualify for and your interest rate, among other things. If you have questions about how your financial picture will affect your home loan, talk to your mortgage banker. They are there to help and provide clarity throughout your home buying process.
It’s also important to keep in mind that you may qualify for a loan amount higher than what you’re actually comfortable paying.
Just because you qualify for a $200,000 loan, doesn’t mean you have to choose a $200,000 property. Borrowing the max loan amount you qualify for may stretch you beyond your financial means, which can be stressful and take some of the joy out of homeownership.
Are you living above your means?
Your financial stress level may be an indicator that your finances are spread too thin, but there are a few other red flags that may signal you’re living above your means.
A low credit score
You already know that your credit score is an important factor your lender will consider, but a low score can also be a sign that you’re struggling financially. A credit score between 649 and 550 may be considered less than desirable credit, while anything 550 and below is considered poor credit. If your credit score is below 600, you may have a hard time getting a home loan.
Since your score shows your ability to repay your debt, a lower score signals that you have had trouble making payments in the past. Maybe you’ve made a few late credit card payments, or couldn’t afford your full student loan payment last month. This may be because you’re living above your means.
A bad credit score affects more than just your ability to get a home loan:
Many landlords check your credit before they allow you to rent from them.
Your credit score can directly affect your loan interest rate and insurance premiums. Generally, a lower score means you pay a higher interest rate and more for insurance.
A potential employer can pull your credit (with your permission) if they choose to when considering you for a position.
When you apply for any other loan, like a car loan, your lender will check your credit. This is also true when you apply for a credit card.
The good news is that you’re not stuck with the same credit score forever. There are plenty of tips and tricks to improve your credit score.
More than 28% of your income goes toward housing costs
How much of your income goes toward your housing costs every month? This applies for both homeowners and renters. If more than 28% of your paycheck goes toward your mortgage payment or rent, it’s likely that you’re living above your means. The 28% threshold is a standard in the industry, where it’s been determined that at 28%, borrowers can afford their homes and still maintain a decent standard of living. Anything higher than 28% however, makes it harder for a homeowner to maintain their lifestyle and still make mortgage payments or pay rent.
If you’re unsure, you can calculate your own percentage. For example, 28% of a $40,000 annual salary is $11,200. So, if you’re spending more than $11,200 a year on your mortgage loan or rent, this may be causing you financial stress.
Less than 5% of your paycheck goes into savings each month
Everyone knows that having one or more savings accounts is important, both for retirement funds and for emergency expenses. If you are saving less that 5% of your income, this may be another financial red flag. For example, for an annual salary of $40,000, you should be saving at least $2,000 a year, or $167 a month.
Ideally, you should save as much as you can each month. Savings are important in the long run, but also in case of an emergency. Would you be able to afford a large vet bill if your dog broke his leg? What about extensive car repairs? If your finances are already stretched too thin and you have limited savings, an unexpected expense could put you in over your head.
While 5% is the minimum amount you should be saving, saving more like 20% is actually a much better budget rule. One safe way to plan your bills and savings is the 50/20/30 rule. It suggests that 50% of your net income (after taxes) is allocated for recurring payments, 30% goes towards your flexible spending, and 20% should be used for savings.
Bills are piling up
Paying in installments, whether it be for your car loan or a new TV, is a popular way to pay, but bills start to add up. Between your utility bills, internet and cable bill, cell phone bill, student loans, car loan, and credit card bills, you may begin to feel financially overwhelmed and this may be a sign that you’re living above your means.
Tip: Look at all the bills you pay each month and try to cut unnecessary costs. Do you need all 500 channels, or can you cut it down to the basic cable? Do you even need cable at all, or can you just keep Netflix? Try and be mindful of utility usage, as well. Turn off your lights when you leave the room and don’t leave your ceiling fans running while you’re not in the room. Even the small things will make a difference in your monthly bills.
It’s important not only to understand what a lender looks for when they determine what loan products you qualify for, but also to know that you may qualify for more than you can actually afford to spend each month.
The key is figuring out how much you can truly afford without stretching above your means.
Don’t hesitate to ask your mortgage banker if you have questions about how much you can afford or about the different factors that make up what loan you qualify for.