When considering a home purchase, common wisdom is to meet with a mortgage lender to determine what you can afford. The lender will look at your credit score for approval and interest rate calculation as well as your debt-to-income ratio to determine your maximum mortgage amount. It is important to understand that this mortgage amount (and the corresponding monthly payment) is the maximum you can afford to pay.
Your down payment is also added to the mortgage to calculate the total home price you will be approved to purchase.
It is important to note that lenders may use your gross income to determine your maximum mortgage amount. But remember, your gross income is not your take home pay. It does not take into account taxes, insurance premiums, retirement plan contributions, and any other deductions taken out of your paycheck each month.
Additionally, lenders may not consider any of your monthly living expenses – just your debt payments. So while you may be able to afford this monthly payment, you might not be able to afford other things like eating out, entertainment or new clothing purchases.
Since the lender only provides the maximum mortgage amount you will qualify for, it is smart to do some homework prior to that meeting to determine how much house you want to afford.
Start by putting together a household spending plan.
Include your take home pay, your monthly savings and all of your living expenses. To get the most accurate picture of your monthly living expenses review a couple months of your bank account and credit card statements to calculate what you typically spend on groceries, gasoline, clothing, eating out – anything that is not a regular monthly bill.
Next, estimate all of your future home expenses: taxes, insurance, utilities and home maintenance.
The financial coaches at Foresters Everyday Money1 recommend setting aside at least 1% of the home purchase price for standard maintenance and upkeep each year, and more if it is an older home.
Plug these numbers into your spending plan and then calculate the monthly mortgage payment you will be comfortable paying based on all your expected living expenses.
When you meet with your mortgage lender ask for the home price based on your calculated monthly mortgage payment and expected down payment. Don’t forget to set aside funds for closing costs, which can range from 2 to 5% of the purchase price.
By reviewing your monthly spending and calculating all of your expected housing costs you can feel confident that not only will you be able to cover your mortgage payment each month, but all of your other living expenses as well.