Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



How Big of a Mortgage Can You Afford? Probably Less Than the Bank Wants to Give You


A common question for first-time and even experienced home buyers is, "How much house can I really afford?"

If this is you, don't ask your banker. Your banker is incentivized to make as big a loan as possible, and the math the banks use to determine what you can afford doesn't really work for lower- and middle-income families.

Here's the low-down on how the bank thinks about your loan, and then a helpful place to start to figure out exactly what you can (and cannot) afford.

You want to buy? Let me back up the truck and give you everything I've got
Mortgage bankers are paid, generally speaking, based on the volume of loans they produce. As such, their paychecks are directly correlated to the dollar amount of fees and dollars lent. More fees and more dollars equals a bigger paycheck. 

The problem with this? The bankers' financial incentive is not in any way correlated to what's best for your finances. This conflict manifests in a few different ways.

Most obviously is the train wreck we are all too familiar with that caused the Great Recession and financial crisis. All that was required for a mortgage was a pulse. And in some cases the pulse was optional

The extreme excesses have tapered, but it was only the near-complete collapse of the entire financial system that brought about these reforms. Bankers will still try to up-sell you to take out more money than you need or than you can afford (even if you can afford the loan on paper -- we'll circle back to this point in a moment).

Another example is in the home equity line of credit market, known commonly as HELOCs. If a customer comes to the bank for a mortgage loan with a large down payment, bankers instinctively begin the cross-sell for a HELOC. 

Do you really need a revolving line of credit secured by your home? Maybe, but maybe not. Many individuals use the HELOC to help pay for a child's college education, to buy a car, or perhaps a luxury item like a pool or boat. The bank doesn't care what you do with the money -- if you don't pay it back, they'll just foreclose on your house.

Source: Rennett Stowe.

Lines of credit are designed to be used for short-term funding. Pools, boats, cars, and college degrees are not short-term assets. They are longer term and should be financed with installment debt, the type that is paid back with regular, scheduled payments of both interest and principal.

Would you buy a boat with a credit card? Most people, I hope, would answer this question with a quick "NO WAY!"

Fundamentally, how is that HELOC any different from a credit card? Sure, it has a lower interest rate, but if you don't pay, the bank can take your house. Finance that boat with an installment loan secured by the boat itself, and the worst-case scenario is that you lose your boat.

Mortgage bankers know this, and they don't care. They just want to see the dollars fund bigger and bigger loans. HELOCs that pay for boats but never get paid down just mean more interest into the bank's coffers every month. Bigger loans equal bigger paychecks.

The fuzzy math that justifies a loan you can't afford
Banks use a ratio called the debt-to-income (DTI) ratio to determine how much debt you can afford based on your monthly income and expenses.

Mathematically, it's pretty simple: Add up all of your monthly debt payments (including the proposed mortgage debt), and divide that into your total monthly income (before taxes). 

Standards vary from bank to bank, but a general rule of thumb is that a DTI of between 40%-45% is a good loan. The lower the percentage, the better your cash flow. 

In theory, if 40% of your monthly income goes to pay debts, the remaining 60% is sufficient to pay taxes, utilities, health insurance, buy groceries, support some level of a social life for you and your family, and ideally, save or invest.

Sometimes the ratio works as it was designed to. The problem is when it doesn't.

Let's break down the math. First, let's talk about the local physician making $150,000 per year with a DTI of 40%.

The good doctor brings home $12,500 per month before taxes. Subtracting 35% for taxes and 40% for his debts, the Doc has $3,125 left over each month. That's plenty of cash for all of life's other necessities, but not a whole lot of other spending. So in this case, 40% seems like a decent ratio to mark the higher end of affordability.

But the Doc is not the average American. He earns three times the average American, in fact. So let's now turn to the median U.S. household and see how DTI stacks up.

A family earning $50,000 per year brings in $4,167 per month before taxes. Again subtracting 35% for taxes and 40% for debts, this family is left with just $1,042 to pay for everything else.

Think about how much your health insurance costs each month (if you don't know, look for the number on your next paycheck). Think about how much you typically spend at the grocery store. Think about your heating bill this month as we all hunkered down during the "polar vortex." Is $1,042 enough? Hardly. But the bank thinks it is. 

Don't rely on the bank to tell you what you can afford
Just digging into the numbers, here, it becomes clear very quickly that the game is somewhat rigged. The bank collects a hefty fee for each loan it originates. It collects a handsome amount of interest over the life of the loan, and so long as there is no massive real estate market collapse, the bank has solid collateral to get its principal back in the worst-case scenario. 

The bank wants you to take out the maximum amount you can afford on paper -- based on its standards. And to be honest, its standards aren't worth the paper they're written on. 

Do your own analysis. If you don't know where to start, go here for a step-by-step action plan. Complete a budget if you haven't already. Understand your cash flow inside and out.

And when the banker begins talking about a larger loan or a HELOC that you don't need or want, stand up from the desk and head over to your local credit union for a second opinion.

Need help saving for your down payment? Today is the day to start investing
Millions of Americans have waited on the sidelines since the market meltdown in 2008 and 2009, too scared to invest and put their money at further risk. Yet those who've stayed out of the market have missed out on huge gains -- gains that could have been the boost needed to finally afford the home of your dreams. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.

Have a comment or question about real estate, banks, or financial stocks? Like Jay on Facebook and leave your question or comment!

Read/Post Comments (0) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2788486, ~/Articles/ArticleHandler.aspx, 8/28/2015 1:15:10 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Jay Jenkins

Anticipating opportunity, filtering out the noise, and figuring out what it all has to do with the price of rice in China. Like me on Facebook here!

Today's Market

updated Moments ago Sponsored by:
DOW 16,613.71 -41.06 -0.25%
S&P 500 1,983.53 -4.13 -0.21%
NASD 4,818.16 5.45 0.11%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes