Bank vs. budget: How much house can you afford?

July 26, 2011, 1:23 pm By Tim Parker Investopedia.com

Be real with yourself and when you make your calculations, plan for the worst case scenario.


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We hear it all the time. The Australian housing bubble is bound to burst. If you noticed that a certain (expensive) home calls out for you each time you drive by, the obvious but most important questions must be asked: Can you really afford it?

Who Decides?

Your bank or lending institution decides. They will look at your application and based on a predefined set of criteria and decide if you can afford the home. You've probably heard that it's much more difficult to get a loan following the GFC. That's true!

What Do They Look For?

Sometimes we think that our mortgage applications are judged by a person who uses a gut feeling rather than objective criteria. That's not the case. In fact, even if your mortgage lender was having a bad day, you can rest assured that there is a predefined set of criteria that not only tell the lender if you're approved or not but also what your interest rate will be. Wouldn't you like to know what those criteria are?

1. Credit History

No secret here, right? For most, a home is the largest purchase they will ever make and, in turn, the largest loan they will ever need. This is when your flawless credit that you've worked so hard to establish and maintain is going to pay you back. The better your credit, the lower your rate.

We should mention this now: If you know that you're going to be looking for a home in the future, work on your credit score now. There isn't a lot that you can do to remove accurate entries but you must keep a close eye on your reports. If there are inaccurate entries, it will take time to get them removed and you don't want to miss out on that dream home because of something that is not your fault.

2. Down Payment

What are you giving them? If somebody asked you to lend them a large amount of money, wouldn't it make you feel better if they gave you something that you could keep if they don't pay you back? The banks feel the same way! The more they get from you upfront, the safer they feel. A higher down payment can also help offset negative entries in your credit report.

Banks want more money down than they used to so plan for a 10% down payment. Also remember that if you can put at least 20% down, you will avoid private mortgage insurance.

3. Debt to Income Ratio

Before we look at this, you have some homework: You have to total up the amount of monthly payments you make. Then, total up your gross pay, the amount of money you make before taxes and other deductions which are subtracted from your paycheck.

Do you have it now? This is a vital metric that banks use to determine your eligibility. The debt to income ratio (DTI) looks at the amount of money you owe on a monthly basis and compares it to the money you make each month. The number is shown as a percentage of your gross income.

In other words if you pay $2,000 each month in expenses and you make $4,000 each month, your debt to income ratio is 50%. (50% of your monthly income is being used to pay debt.) Here's the bad news, a 50% debt to income ratio isn't going to get you that dream home. If you're over 36%, you will be considered a higher risk borrower. Each institution will have slightly different DTI requirements.

4. Your Income

If your DTI (debt to income ratio) is 25%, but you only make $10,000 per year, you aren't going to get that home. We won't spend too much time on this because the obvious guideline is that the more you make, the better you look to the bank.

The Real Decider of Your Loan

The real person who should decide if you can afford a home is you and you have to put your emotions aside. Dave Ramsey, best selling consumer finance author and speaker believes that you shouldn't use any more than 25% of your take home pay (net pay) on your mortgage payment. This is different than the bank formula which uses your gross pay.

The problem with using gross pay is simple: How much of your check is deducted before you get your money? Thirty-percent? Why would you factor in money, most of which you won't ever see? Even if you get it back on your tax return, that doesn't help you now - and how much will you really get back?

What can you realistically afford? That dream home may be everything you've wanted at a great price but is it worth overextending yourself and your family? Is it worth potential bankruptcy if you lose your job?

The Bottom Line

The bank may tell you that you can afford a huge estate making you look like a Hollywood celebrity, but can you? Be real with yourself and when you make your calculations, plan for the worst case scenario. Murphy's law states that if it can go wrong, it will. As Dave Ramsey says, if you leave your front door open to Murphy, Murphy will move in.


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