Q: My husband and I are trying to buy a larger home for our growing family. The homes we like would be a big stretch for us financially. Our credit is good and our mortgage banker assures us we can qualify for the mortgage we would need, but it scares us. I guess my question is how much home can we really afford?
A: I understand how scary it can be to take on a big mortgage. Unfortunately, big mortgages are a fact of life for most people in California. According to a survey by the credit agency Experian, Californians have the second highest average outstanding mortgage balances in the country next to Washington, D.C..
Looking for advice on mortgages can be tricky. A mortgage banker will tell you their lending limits, but they don’t know enough about your personal financial situation to tell you what your borrowing limit should be. In fact, if you borrow as much as a mortgage lender is willing to give you, I can almost guarantee you won’t have enough money for your other goals.
Mortgage underwriting relies heavily on a metric called the Debt-to-Income ratio or DTI. DTI is calculated by adding up the monthly payments required to service all your debt, including your mortgage, student loans, car payments, credit cards, etc. PLUS property taxes, homeowners insurance and HOA fees and dividing them by your gross income. Generally, mortgage lenders like to see DTIs less than 43%. However, if you borrow up to that 43% DTI limit, you are going be house poor.
Let’s suppose your household annual income is $100,000. If you have good credit and no other debt, you can probably qualify for a $500,000 mortgage. Assuming a 30-year fixed-rate mortgage at 4% interest, your monthly payment (including property tax and insurance) will be close to $3,300. That leaves you with about $2,300 each month to pay for all your other expenses—not much when you consider the cost of food, clothing utilities, medical care, home maintenance and transportation.
A better way to think about your mortgage is to figure out how much of a house payment you can afford without neglecting your other financial priorities. Once you have that number you can work backward to see how much house that payment will buy. If you go the other way (i.e., finding the house you like and then trying to qualify for the mortgage you need to buy it) you will likely overspend. We all tend to want more than we can actually afford.
Long-term goals are often the most vulnerable to this tendency. People often sabotage themselves because they fail to make the short-term sacrifices that produce the long-term benefits they desire. They buy too much house for their income and they don’t have enough resources left over to properly save for retirement or their children’s education. Make sure you include long-term goals in your cash flow planning for your mortgage.
Finally, build some cushion into your mortgage payment. If your budgeting process shows that you can afford a $2,500 per month mortgage payment, settle instead for $2,000 per month. That extra cushion will give you added resilience when you confront the inevitable challenges of life.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.