You have decided to start the home search, and you’ve made the smart choice of going to the bank and getting a preapproval. They’ve given you a letter, with a number on it, and it’s supposed to be the dollar amount they tell you that you can afford to pay for a home. But what does this mean for you? How much are you really going to have to pay each month, given you purchase a home for that specific dollar amount, and how much are you going to have left after you make your mortgage payment? Many homebuyers are not aware what that number could potentially do to their wallets every month, and how it could affect you down the road. When a lender gives you a preapproval letter, they do not have raw numbers to be able to calculate how much your homeowners insurance is going to be, or if you will have to pay flood insurance, or mortgage insurance. What many people do not realize, this is the MAXIMUM amount you are preapproved for. This is the number the lender says you can afford on paper, not necessarily what you CAN afford. Lenders don’t do this to put you in a bad predicament, they simply give you the amount you are preapproved for, based upon the information they’ve been given, and the formula they use to calculate the number.
Lenders calculate how much you can actually afford similar to the way you should. You will factor in your income, your debt, and some facts about the home. An important factor lenders look at is debt to income, or DTI. Debt to income is how much you are paying out in debts, compared to how much you earn in income. Lenders consider “debt” a little differently in DTI. In this ratio, they only include mortgage payments, real estate taxes and insurance (only if they are escrowed), loan payments, time share payments, child support, alimony, any debt you may have co-signed for, and credit card bills. Other obligations including utilities, cell phone bills, groceries, health insurance, car insurance, etc. are not included. Your income is calculated by gross monthly income. To calculate your monthly debt to income, you will divide your monthly debt ÷ gross monthly income = monthly DTI. A rule of thumb is, 36% or less of your monthly pretax income should pay your debts. 28% or less should be dedicated to your mortgage payment, while the remaining is dedicated to loans, credit cards, child support, alimony, etc. The other 64% of your monthly income is then spent on your income taxes, groceries, utilities, savings, etc. When you are home shopping, you can calculate these numbers yourself using as estimate of the mortgage payment, taxes and insurance, to ensure you will fall within range.
So, how does this help when shopping for your new home? A preapproval letter from a lender is always going to be recommended in the real estate industry. This will give you a starting point of price ranges to look for. Best practice however, is to look lower than the price you are preapproved for, to avoid maxing out your budget. If you do find your dream home at your maximum preapproval amount, the good news is, your lender says, you can afford that payment on paper. You may find you need to reevaluate your spending habits however. When you find a home, and you want to estimate your monthly cost, you can do so. Your realtor should be able to get the property’s current year tax rates, and the homeowner’s current insurance cost. Keep in mind however, your insurance coverage may be different, therefore a different cost. Your lender, with a purchase price, interest rate, down payment (if less than 20% down payment, you may be liable for mortgage insurance, creating additional monthly costs), term length, property taxes, and insurance rates, will be able to give you an estimated monthly payment amount including and excluding escrow if you wish. You may also find mortgage calculators online, most do not include escrow.
Just because a lender is willing to lend you a specific dollar amount, does not mean you have to take it! CNN Money published an article that supported the opinion, “On average, you should aim to purchase a home around 2.5Xs your annual salary.” Perhaps it’s not that cut and dry. Everyone is at a different financial point in his/her life, and everyone’s spending habits are not the same. If you put two financially equal people side by side, they may not both be able to afford the same home. We all have different financial goals, and expect different things for our futures. Expect the unexpected, and best of luck in your home quest!