“I don’t know how much I can afford to spend on a house, so I’m going to pre-approved by a mortgage lender. They’ll be able to tell me how much I can afford.”
I hear first-time home buyers say this kind of thing all the time, and it always disturbs me. It’s indicative of a false and dangerous notion that is prevalent among U.S. home buyers — the idea that a bank can tell you what you can afford. This notion is dead wrong, and it’s also my motivation for writing this article.
If you rely on a mortgage company to determine your home buying budget, you may end up spending a lot more on a house than you can afford. “How is this possible?” people often ask. “Why would a bank give me more money than I could afford to pay back?” I’ll tell you why, and I’ll also tell you how to avoid such mistakes when getting a mortgage loan.
How Much House Can You Afford?
You are the only person who can determine what you can afford to pay each month, in the form of a mortgage payment. A lender cannot tell you this. They can only approve you for a certain size of loan — but that’s it. Their responsibility stops there. The lender is not your financial advisor or your friend. They are in the business of making money by charging interest. Period. End of story.
So before you start talking to mortgage companies … before you try to get pre-approved for a home loan … and before you start the house hunting process … you need to determine your monthly budget and maximum spending limits. Many home buyers skip this step altogether, relying on the lender to do it for them. That’s why we have so many home foreclosures in the Untied States — people set their common sense aside and rely too heavily on the judgment of mortgage lenders. Big mistake.
Here are the steps you should take before you start talking to lenders:
Add up your monthly expenses and write that number down on a piece of paper. You can exclude your rent payments, because those will go away when you buy a house.
In your expenses tally, be sure to include everything you spend money on each month. Car payment and insurance, other insurance premiums, credit card payments, groceries, savings, entertainment and recreational expenses, etc. Everything but your rent.
Next, write down your net monthly income. This is your “take-home” pay, after taxes are taken out.
Subtract your monthly expenses from your monthly net income. This is the amount you have to put toward a mortgage payment each month. Your monthly payments on a home loan should not exceed this amount. If they do, you are buying too much house!
Now that you have a firm budget established, you can get pre-approved by a lender to see what they’re willing to lend you.
Here’s the bottom line. It’s possible to get approved for a mortgage that’s too big for you. Banks do not care about affordability as much as they once did, because they know they can sell the loan into the secondary mortgage market (through Freddie Mac). So if they give you a loan that’s too big for you, and you end up defaulting on that loan down the road, it’s not their problem.
So say it with me: “The mortgage lender is not my financial advisor. They are not looking out for my best interest. They are in the business of making money — period. I need to establish my own monthly budget and spending limits, before I start talking to lenders.”
Repeat this mantra as you enter the home buying process, and you’ll be on the path to success. If you ignore this mantra, you could become yet another foreclosure statistic down the road.
Citation Note: The original version of this article was written by Brandon Cornett. Brandon is the publisher of the Home Buying Institute, which includes one of the largest libraries of mortgage advice for home buyers.