How Much Can You Afford?

The first step in finding a home is figuring out how much you can afford to spend.  We’ll look at six different factors to consider when making this decision, with three of them related to mortgages, and the other three focused on broader personal considerations, such as how long you plan to own the home.

The mortgage is probably the biggest hassle facing prospective homeowners.  The bank will want to ask you all sorts of nosey questions about your income and savings (or lack thereof), and then might not even lend you as much as you need.  The nerve of them!

Of course, there is a reason for this.  Put yourself in the bank’s shoes;  If you were going to lend people money, what would you want to know about them?  Basically, you’d like to know 1) if they make enough money to pay you back, 2) if they’ve been trustworthy in the past, and 3) if they have something of value should they be unable to pay you back.

Congratulations:  In financial parlance, you’ve just been introduced to the concepts of income, credit worthiness and collateral.  Let’s look at each one, and how they affect what you can afford.

Do You Make Enough to Pay Back the Lender? They will want to know not only how much money you have, also how much you will make over the next 10-20 years.  Also, do you have other debts?  Owe money for student loans or credit cards?  Do you have any other assets?  Things like investments or personal property like a boat or a car are also included.

Ideally, you will have at least 20% of the value of your new home as a deposit, to avoid things like mortgage insurance payments.  But, you probably could get you into a new home for as little as 5.0% of the asking price.

Lenders will also pop your income numbers into a formula: Let’s say your gross income is $4000 a month.  A rule of thumb is they’ll allow you 35% of your gross income toward mortgage payments.  In this example, 35% of $4000 – so they’ll put $1400 to mortgage payment.

Have you been trustworthy in the past?  What is your credit rating?  The major credit reporting agency in New Zealand – Baycorp. You can request credit reports individually if you wish.

Your credit report – a little compilation of your personal financial history – will reveal if you pay your bills on time.  If not, clean up your rating to make you more attractive to lenders.

Do you have any collateral?  The house will generally be collateral for your mortgage.  As a result, in case you can’t repay the loan, the bank can decide to do something really nasty: Sell the house via mortgagee sale.  You will find yourself out on the street – with your dog, a couple of suitcases and your toiletries kit.  Your house now belongs to the bank and it is unlikely anyone will ever loan you money again.  Hot tip: avoid this at all costs.

Your considerations. How much you make, your creditworthiness, and how much collateral you have are all questions from the bank’s point of view, because how much house you can afford is largely a question of how big a loan you can afford.  Lets look at a few things from your point of view.

Your timetable. To determine whether you should buy a home, think about how long you’re planning to stay.  It generally doesn’t make economic sense to buy if you are only planning to stay for one or two years.  Why?  Because you’re going to pay fees to buy and then to sell your house.  It would have to appreciate in value strongly between buying and the time you sell to make it financially worthwhile.  In other words, you’d have to get lucky.

Your comfort zone. Before you leap in and borrow $250,000 or $350,000 or whatever you need figure out whether you can really afford it.  Just because the bank will loan it to you, doesn’t mean that you will live your life in such a way as to be able to pay it back.  Planning to have a family?  Would you rather replace your old clapped out banger with a new SUV?  Your house payment is just one piece of your financial puzzle.  What might you need to give up too make that house a reality and are you really willing to do so?

Original Article published July 2005