The short answer is: less than the bank will tell you that you can “afford.” Never let anyone tell you how much you can afford. The banks and credit card companies are businesses. They will offer you terms that are favorable to them. This is not “mean” or “bad.” It is one of the cornerstone principles to building wealth. This principle states: The terms offered are always offered in favor of the person offering them. Translation: If I am offering you a deal, it works for me. It’s up to you to determine if it works for you. This is exactly what the bank is saying when they calculate how much of a mortgage they are willing to offer you. Of course, they are only taking into account your request for a mortgage.
They are not factoring in your other financial goals. This might sound obvious, but if it was as obvious as it sounds, it would have been difficult for the 2008 crisis to happen as it did! As we know, there was reckless lending on behalf of the banks, but there was also reckless borrowing. People were not calculating if borrowing as much as they were offered was good for their financial situation. Owning your own house can be a dream come true, but this is too big of a purchase to be influenced by desire alone. You must factor in your other long-term goals. How do you do this?
Focus on the monthly payment you can easily afford
You never know what’s going to happen. You could lose your job. Your job could move you across the country. Since you never know exactly what will happen, flexibility is king in finance. That being said, owning an apartment or home can have some incredible advantages. The goal is to balance the two. If you have decided now is the time to buy, here are some of the tricks I use to keep some wiggle room in my budget.
First, I amend the bank’s guidelines. They will grant me a mortgage based off 28% of my pre-tax income. This is a huge chunk of your after-tax income. A quick example: If you earn $100,000, 28% of your pre-tax income breaks down into monthly payments of $2,333. This would make your mortgage payment 41% of your paycheck. That’s going to make life feel tight! I like to keep the payments to 28% of my after-tax income. (This includes taxes, insurance and maintenance.) This way, if my husband or I suddenly can’t work, we can still pay the mortgage on a single income. This trick does double duty. We can still save, fund our other goals, have a good time and own an apartment. On top of that, we are protecting our investment. If something happens, we can still afford our mortgage payments, or rent it out and have a positive cash flow. This protects our down payment, which is really the home run. That down payment was a huge chunk of my life savings. To have it vanish by an unforeseen event would be heartbreaking, to say the least. I live in New York City, the land of the million-dollar-one-bedroom apartments, and I was still able to abide by this rule of thumb. Two things that helped were that I had a great credit and that I waited to buy until I could put 20% down.
Get the best rate
You need a 740 FICO score to start qualifying for the best mortgage interest rates. Your score is recalculated on a monthly basis, but some things take months to correct. The two things that affect your score the most are paying on time, and your debt-to-credit ratio. I don’t have to explain paying on time, but I do want to jump on my soapbox for a second and say, “Set your credit card up on auto pay, and never miss a payment. It is like getting black lung. It kills great credit, and it takes a long time to repair the damage.”
However, there is a nice, quick trick to help your debt-to-credit ratio. (This ratio is calculated by adding up all available credit and dividing it by all outstanding debt.) This counts for 30% of your score. Ideally, you want to have under 30% of usage. (Example: If all my available credit is $10K, and all my combined balances are $3K, my ratio is 30%. Just on the edge of great.) Now, if you calculate your ratio and find you’re using more than 30%, and you don’t have the cash because you’re saving it for your down payment, you can call the credit card companies and ask them to increase your credit limit and … voila! You instantly have a better ratio. (Well, within 30 days, the time it takes to get reported to the agencies.) Finally, don’t close or open any cards a year before you apply for your mortgage. Doing this toys with your debt-to-credit ratio and your length of credit history.
Put 20% down.
Although all rules are made to be broken, putting 20% down is a general guideline that I like to follow. Putting 20% down does three incredible things. First, it lowers your monthly payment, so it allows you to buy the most while still following the “28% of my after-tax income” rule. Secondly, you eliminate having to get PMI or private mortgage insurance. If you don’t put 20% down, you have to pay this until the equity in your home becomes 20%. This money is cash you can never get back, and it can easily add up to $10,000+. It also eats into your monthly cash flow, making that mortgage payment feel bigger! Lastly, you instantly start building equity above 20% in your home. This is like building an extra line of security. If something completely unforeseen happens, instead of having to sell your house, when the timing might suck, you have the option to take out a home equity line of credit. This can only be done if you have 20%+ equity in your home. Of course, this is an emergency scenario, but this is how you build a strong financial position, by factoring in the unexpected, and not just the best case scenario.
Do you know what’s in your 401(k)? A free, 15-minute call could save you $100,000 or more. Contact me; it’s not scary. I promise.