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Don't Make This Mortgage Mistake in 2016

By Matthew Frankel, CFP® - Jan 31, 2016 at 8:19AM


Too many people over-extend themselves when buying a home. Don't be one of them.

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There are plenty of good reasons to buy a home in 2016. Mortgage rates are still historically low, rent is increasing faster than home prices, and buying a home can allow you to start building equity instead of just giving your hard-earned money to a landlord. However, keep in mind that when you go shopping for a home, the loan amount you can qualify for and the amount you can really afford might be two different things.

Buying is cheaper than renting -- sort of
Many people (including myself) have written that owning a home can be cheaper than renting in most U.S. housing markets. And, it's true. For example, in my local market, an entry-level three-bedroom home in a good school district rents for around $1,200. Meanwhile, the same home can be purchased for about $125,000, which translates to a $477 monthly mortgage payment -- assuming a 4% interest rate and 20% down. Even including taxes and insurance, the payment is likely be no more than $700.

The problem is that people tend to buy a larger and higher-end home than they would be willing to rent. Renting is not cheaper than owning if you buy a home with twice the square footage, a high-end kitchen and bathrooms, and a big yard.

How much can you get approved for? You might be surprised.
Lenders traditionally use something called the 28/36 rule to determine how much you can afford to spend each month on your mortgage, including principal, interest, taxes, and insurance.

The "28" is called the front-end ratio, and it says your mortgage payment cannot be more than 28% of your pre-tax income. The "36" is the back-end ratio, and says that your total monthly debt payments including your mortgage cannot exceed 36% of your income. Your maximum mortgage is limited by whichever ratio produces the lower payment amount.

These numbers are by no means set in stone, and it's fairly easy to get approved for a higher debt-to-income ratio. For example, it's possible, through many lenders, to obtain a 45% debt-to-income mortgage if you have decent credit and a few months' worth of mortgage payments in reserve. To illustrate this, if your salary is $100,000 per year, and your other debt payments (car, credit cards, student loans, etc.) are $800 per month, you could potentially buy a $558,700 home at a 45% total debt-to-income ratio, assuming 20% down. If you think this sounds like too much to spend on a house for someone who earns $100,000 per year, you're right.

Don't forget the hidden costs
Your mortgage payment is just one part of the true cost of homeownership. When formulating your budget, keep the following expenses in mind:

  • Property taxes and homeowner's insurance -- Yes, these are generally taken into account when your lender determines how much you can afford. However, keep in mind that these change every year, and usually not in your favor. Even with a fixed-rate loan, your monthly payment is likely to increase over time to keep up with these costs.
  • Maintenance -- You'll need to replace carpet when it wears out, put a new roof on the house every 15-20 years, and perform smaller maintenance tasks such as changing air filters regularly. When renting, your landlord generally covers maintenance, so be sure to account for this.
  • Landscaping -- If you move from an apartment to a house, you'll have a lawn to care for. Even if you don't do any elaborate landscaping, factor in the costs of maintaining your lawn.
  • Repairs -- When you own a house, things break. Six months after I bought my first house, the HVAC unit completely died, and replacing it was not cheap. Even if you're buying a brand-new home, plan on at least a few unforeseen repairs.
  • Utilities -- Don't forget the cost of heating or cooling your new home. If it's significantly bigger than your previous home, this can make quite a difference in your costs. Similarly, other utilities may be greater -- as a personal example, my current house is equipped with a sprinkler system for the lawn, and I severely underestimated the cost of running it. As a renter, your landlord may even cover certain utilities, such as sewer and trash.
  • HOA dues -- These can vary drastically, or you might not have a homeowners' association at all. Either way, be sure you know about them before you put your offer in.
  • Mortgage insurance -- If you put less than 20% down when you buy your home, you'll probably have mortgage insurance added to your monthly payments.
  • Furniture -- Finally, don't forget that if you move into a bigger home, you'll probably want to fill it up.

Don't lose sight of long-term financial goals
I want to be completely clear -- buying a home can be a smart financial decision, but it isn't an investment. Before you decide to sink half of your monthly income into your housing expenses, be sure you have enough left over to save and invest for your future.

Depending on who you ask, it's generally suggested that you save 10% to 15% of your salary in a 401(k), IRA, or other retirement account. When you're figuring out your home affordability, be sure to take this into account -- it is arguably the most important expense you should plan for.

Only buy what you need
If you need to fully extend your budget in order to meet your housing needs, that's one thing. For example, if you live in a high-cost area like New York City, it's completely understandable to spend a large portion of your income on housing.

However, just because you can buy a certain amount of house doesn't mean you should. If you were approved for a credit card with a $30,000 limit, does this mean that you should run out and spend $30,000 on things you don't really need? Of course not. The same logic should apply to your home purchase.


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