House On Money

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When shopping for a mortgage, you'll probably either use an online calculator or a pre-qualification quote from a lender to determine how much you can get approved for. Keep in mind, however, that just because you can get approved for a certain amount doesn't mean you should actually spend that much.

Here's how banks determine how much you can qualify for and how to determine what your budget should really be.

How much house can you qualify for?
Traditionally, lenders have used something known as the 28/36 rule to determine how much of a mortgage you can qualify for. This refers to two income ratios that provide guidelines for your maximum monthly payment.

The "28" is known as the front-end ratio and says that your mortgage payment, including taxes and insurance, shouldn't exceed 28% of your pre-tax income. The "36" is called the back-end ratio, which means your entire debt load, including your mortgage payment, car payment, credit cards, student loans, and other monthly payments shouldn't exceed 36% of your pre-tax income.

Some lenders will stretch these limits even further. For example, if your loan is a qualifying mortgage under Fannie Mae's underwriting standards, and you meet a few other requirements, you can qualify for a debt-to-income ratio of up to 45%. In other words, if your monthly paychecks are $5,000 before taxes, you could qualify for a mortgage as long as it doesn't cause your monthly debt load to exceed $2,250.

Five tips to set a realistic budget
Just because you can buy something doesn't mean you should, and this is especially true when buying a home -- likely the biggest individual purchase of your life. 28% of your pre-tax income could easily be half of your actual take-home pay. So, before you commit to giving up half of your income by purchasing the biggest and best house you can qualify for, here are a few things to keep in mind when deciding how to set your house-hunting budget.

1. If it applies to you, the most important advice I can give is to keep your other debts in mind when designing a monthly budget -- particularly any credit card debt you might have. I realize lenders take all of your debts into consideration, but they only look at your minimum monthly payments. For example, you can have a minimum payment of $500 on $30,000 worth of credit card debt at 18% interest, but you'll be paying off the debt for 13 years and will end up paying nearly $78,000. My point is that making the minimum payments are by no means enough. It's worth lowering your housing budget to ensure you'll be able to pay your high-interest debts faster.

2. Don't forget about your other expenses that are not part of the qualification process. When lenders evaluate your debts, they only look at those accounts that show up on your credit report, which basically means credit cards and any bank loans you may have. An evaluation of your ability to afford a home doesn't include your other ongoing expenses such as:

  • Groceries
  • Dining out
  • Cable
  • Utilities
  • Gasoline
  • Gym memberships
  • Auto insurance
  • Entertainment
  • Travel expenses
  • Clothing

Your "official" debts should be just one piece of the puzzle. Before deciding on a budget, consider these and other expenses and how your housing choice may force you to cut back.

3. Don't forget about the variable costs of homeownership. Your lender will qualify you for a mortgage payment based on your property taxes and insurance costs for this year. Unfortunately, these expenses change every year, and usually not for the better. You should also consider maintenance and repairs -- after all, if your budget is already stretched to the max, the last thing you need is for the HVAC system to die, or for the roof to start leaking.

4. You need to allow enough extra income to save for emergencies and for your own retirement. This may sound like a no-brainer, but you may be surprised at how many people don't do it. According to a Federal Reserve report, nearly half of Americans couldn't cover a unexpected $400 expense without using a credit card or otherwise borrowing the money. It doesn't make any sense to have a big house if you'll be living paycheck to paycheck.

5. Finally, evaluate your needs as opposed to your "wants." Sure, it would be great to have a home with a pool, two guest bedrooms, a home theater room, and a steam shower, and it would be even better if you can fit all of that into a reasonable budget, but the reality is, you probably don't need all of those things. Just because you qualify for it doesn't mean you need it.

A mortgage is like any other debt
If you were approved for a credit card with a $20,000 limit, does that mean you should run out and spend $20,000? Of course not. Just because you have the ability to buy something doesn't make it a good idea.

Unfortunately, too many people don't apply the same logic to buying a house, instead preferring to buy as much house as possible. If you need a big house, or if there is a legitimate reason to buy a house at the top of your budget, go for it. My point, however, is to get you thinking about the big picture, how much that big house is really going to cost, and whether or not you should lower your housing budget to put some of your income to better use elsewhere.

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