How To Best Determine Home Affordability
Whenever you visit a financial institution for a home mortgage, they’ll probably ask you how much you are willing to spend on the property. The banker will suggest a figure based on your earnings and financial obligations if you’re unsure.
Unfortunately, that could be a debt trap because the lender’s suggestion doesn’t mean you can afford the mortgage. Lenders only tell you the maximum amount they are willing to risk in advancing the mortgage.
So before you set out in pursuit of your dream house, ask yourself how much you can comfortably afford to spend on the home. Do not decide based on what the financier may be willing to lend you.
This article will focus on helping you understand the real cost of buying a home.
A Case Example:
Walter and Susan secured a $900,000 mortgage based on an adjustable interest rate. At first, it seemed like the mortgage helped them acquire their dream home. However, years later, trouble began.
While ignoring their other significant financial obligations, the couple assumed the bank’s estimation of their loan limit was sufficient.
The couple got more children, hence had to work extra hours to offset the mortgage balance and meet family expenses. Initially, their mortgage payment was low, but as time passed, the adjustable-rate meant that their interest could change as well. Soon, they began paying high-interest rates, contrary to their expectations.
As a result of financial strain, they began arguing about insufficient money and child care. Finally, interest rates hit unmanageable levels, prompting the couple to default on the loan. As a result, they lost their property and earned a bad credit score. Eventually, Walter and Susan divorced.
Calculating Your Mortgage Payment
Home loans form the largest share of expenses relating to property ownership. But they guarantee ready cash for prospective buyers to own property.
For instance, using a $200,000 mortgage, you can buy a home worth almost the same amount, despite having far less cash in your pocket.
Mortgages are payable over a long duration, usually 15 or 30 years. But the longer you take to pay the loan, the more you will likely pay the bank.
Say, for instance, that your financier offers you two options to choose from; a 15-year fixed rate and a 30-year fixed rate.
Your monthly interest would be as follows:
- $160,000 mortgage, payable in 15 years at 4.75% interest rate =$1,245 per month
- $160,000 mortgage payable in 30 years at 5% interest rate=$859 per month
From the above rates, we can draw a few conclusions;
The interest rate for both loans is fixed over the entire loan period. However, the rate for a 15-year mortgage is lower because lenders consider short-term loans to carry less risk.
The payment for 15 years is more than that you’ll pay in 30 years. If you opt for a shorter payment period, you are paying the same loan faster.
A 15-year mortgage attracts a higher monthly payment, but don’t forget that you’ll clear it in only 15 years. However, a 30-year mortgage has a lower monthly payment, but you’ll pay for 15 more years to clear your loan. Eventually, you’ll pay more interest and outstanding balance for a longer duration.
Understanding Lending Limits
Mortgage lenders use set criteria to approve your mortgage application and determine the maximum you can borrow. Collectively, lenders refer to your borrowing limit as housing expenses.
Thus, they can tally your housing expenses using the formula below:
Housing Expenses = Mortgage Payment (principal and interest) + Property Taxes + Insurance
Your housing expenses should not exceed 40% of your gross income before taxation for most banks. However, some financiers may be lenient enough to accept a higher percentage.
For instance, based on the 40% cut-off mark, if you earn a gross income of $6,000, your financier will not allow you to exceed $2,400 in housing expenses.
In addition, banks consider other significant debts when calculating your borrowing limit. For example, they will check for your student loans, credit card bills, and auto loans which should not exceed 5% of your income before tax. Thus, your housing expenses and significant debts should not exceed 45% of your pre-tax earnings if you want a mortgage.
The downside of the lenders’ formula is that it ignores other notable financial obligations such as remodeling, maintenance, and utility costs. If you overlook such massive costs, you risk falling into a huge debt trap when you add a home loan.
Stretching More Than Your Limits
It is not uncommon to find prospective buyers borrowing more than their limits can allow. The upside is that you’ll acquire a bigger property that meets your taste. However, you may end up in financial, emotional, and legal turmoil if you can’t offset the mortgage.
Moreover, lenders may deliberately request a copy of your income tax report from the IRS to ascertain your income. This may subject you to the liability of fraud if it turns out that you borrowed more than you can afford to pay.
How Much Can You Afford?
Buying property using a mortgage is commonly a significant investment you can make. But how much you can borrow depends on a variety of factors, other than how much a bank is willing to offer you.
First, it’s good to know what your lender believes you can pay. Second, you must conduct personal reflection to determine the type of housing you are willing to buy. Your choice largely depends on your financial situation and individual preferences.