How to Right-Size Your Mortgage

If you’re thinking about buying a house, you’re probably looking at mortgage rates. And that’s helpful… but it’s only one tiny piece of your home/mortgage puzzle.

The most important number here is the right amount to borrow.

Lenders want you to borrow as much as possible, encouraging you to buy the maximum house their willing to finance. They’ll offer you the largest possible loan based on how your finances look on paper. Their only goal: to lend you a lot of money for a long time and collect hundreds of thousands of dollars in interest.

Your goal is the exact opposite. You want to borrow the least amount possible and take out the smallest mortgage you can. You don’t want to get a mortgage that you’ll have to struggle to pay back.

Signing up for a mortgage that strains your budget will make it much harder to meet other financial goals. If you need your full income – or multiple incomes – to cover the monthly mortgage payment, you might not be able to leave a job you don’t like… start your own business… or retire when you’re ready to. Think about all of that before you agree to borrow hundreds of thousands of dollars.

Getting a mortgage you can easily afford might mean buying a smaller house or looking in an area with a lower cost of living. And that might feel disappointing right now… but it will save you a huge amount of money and stress over the long haul.

How Your Lender Comes Up with a Number

All mortgage lenders use slightly different formulas when they’re figuring out how much money they’ll let you borrow and under what terms. But it all starts with the same basic information: your gross income, meaning your paycheck before taxes, retirement plan contributions, and other deductions are taken out.

Mortgage lenders will include a lot of things along with your salary in that gross income number, such as:

  • Bonuses
  • Side gig income
  • Business income
  • Alimony
  • Child support
  • Rental income

From that starting point, they back into the biggest mortgage payment you can afford by looking at things like your credit score and your current debt load.

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Lenders check how much of your annual gross income could go toward repaying your loan, using the full PITI mortgage payment. The PITI includes:

  • Principal
  • Interest
  • Property Taxes
  • Insurance, both homeowners and mortgage insurance (if you’re required to have mortgage insurance)

They use a calculation called the front-end ratio to compare your gross income to the PITI. That tells them how much of your income it would take to cover the mortgage payment, converted into a percentage. Some lenders limit that percentage to 28%, so your housing related costs can’t be more than 28% of your gross income. But other lenders let that ratio run as high as 30 or 35%... and that’s a much higher percentage than most people can easily afford.

Here's an example. Let’s say your gross annual income comes to $60,000. That works out to $5,000 per month, so…

28% = $1,400

30% = $1,500

35% = $1,750

Remember, though, that’s based on your gross income, not how much money you actually take home. So their idea of affordable may totally trash your budget.

Next Up: Your Debt-to-Income Ratio

Your lender will also pay close attention to your debt-to-income ratio, also called DTI. This measures the percentage of your monthly gross income that goes toward paying down debt.

Here’s what they count as debt:

  • The new mortgage payment you’d have with their loan
  • Payments on other loans you have, like student loans, car loans, and personal loans
  • Minimum credit card payments
  • Alimony or child support that you pay
  • Other monthly legal obligations like back tax payments

Most responsible lenders want your DTI to be less than 36% of your gross income… but some lenders will let it go as high as 43%.  

You can calculate your DTI by dividing your total monthly debt payments by your gross income. For example, if your total debt payments come to $2,000 and your monthly gross income is $5,000, your DTI would be 40%.

But, remember, all of these lender calculations are based on your gross income… and that’s not the amount of money you really have available.

Run Your Own Numbers

If you want to be able to easily afford your mortgage, you’ll need to do different math than the lenders do. Your coming at this from the opposite side: How much can I realistically spend on a mortgage payment… and NOT what’s the biggest mortgage I can get.

Your calculations will be based on your net income, the amount of money you have left after taxes and other deductions. That’s the only money you actually have available to pay bills with. So take a look at all of your expenses – including the amount you contribute to emergency and other savings – and come up with own your maximum mortgage payment.

Keep in mind that it might look like lenders care about your budget, but they don’t. What they really care about is selling you a loan so they can make money.

When you’re trying to get approved for a mortgage, it feels like you’re auditioning for them, like you have to sell them on financing your house. But it’s really the opposite. They’re trying to sell you a product – a mortgage loan. And they want you to pay as much as possible.

Remember: The bank is not on your side, and the bank always wins.

According to the NerdWallet 2020 Home Buyer Report, 29% of homeowners stop feeling financially secure after buying their house.

DTI Leaves Out a LOT

It’s bad enough that DTI uses your gross income… but it also leaves out most of your regular monthly expenses. Because it only considers your debt payments, it completely skips over things like:

  • cell phone bill
  • internet
  • groceries
  • streaming services
  • utilities
  • prescriptions
  • child care
  • vet bills
  • clothes
  • and all the other things you spend money on every month

Let’s start by looking at the difference between your gross and net income. For most people, your net can be 25 or 30% less after all the taxes and deductions are taken out. So, right off the top, you already have a lot less cash on hand to cover expenses.

On top of that, your new home probably comes with new expenses. So you’ll want to add in the costs of repairs and upkeep for place you plan to buy, which can include things like:

  • yard work
  • snow removal
  • homeowners’ association fees
  • plumbing and electrical repairs
  • roof maintenance

If you’re moving to a bigger place, you’ll also need to account for things like higher energy costs and more home furnishings. All of these extra costs will show up in your monthly budget. So remember to consider them when you’re figuring out how the maximum mortgage payment you can afford.

Feeling overwhelmed by all of these factors? I can help you figure out your best home-buying budget. Contact me to set up a free… and stress-free… consultation today. 

Remember to Account for Closing Costs

Don’t forget about closing costs as you’re looking into mortgage loans. There are a lot of expenses like transfer taxes and recording fees that go along with buying a home. And all of those costs have to be paid at the closing, when all of the legal documents are signed and the money changes hands.

Closing costs normally add between 3 – 5% of the sales price to your deal. And if you’re paying the realtor’s fees, add another 5 to 10%.

Most lenders will offer to “wrap” those closing costs into your mortgage loan. And that sounds like a good idea, but it isn’t. Adding your closing costs to the loan will cost you thousands of dollars in interest over the life of your loan. So it’s in your best interest to bring enough cash to the table to pay the closing costs outright.

Bottom line: Do your own math before you start shopping for a mortgage. Know how much house you can easily afford. And don’t let your realtor or your lender talk you into going bigger.

Need help figuring out your ideal home-buying budget? I can help. Contact me to set up a free consultation and learn how I can make your financial life easier.

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