When Sarah and Brandon Perkins began shopping for a house last year, they knew exactly how much they could afford to pay each month. But when their lender came back with an approval, they were surprised to see that it was about $25,000 more than the maximum amount they thought they’d spend. The couple could have seen the approval as carte blanche to upgrade, but realized that a higher list price would mean a higher monthly payment — one that didn’t quite fit in their budget.
Since the 2008 financial crisis (which was fueled in large part by a real estate bubble), regulations have been put in place to cut down on predatory lending, most notably through the Title XIV of 2010's Dodd-Frank Act, which is called the Mortgage Reform and Anti-Predatory Lending Act. The act established national underwriting standards for residential loans, but some consumers are still approved for mortgages that are unrealistic for them when it comes to monthly payments.
Tasha Bishop, director of strategic alliance and business development at Apprisen, a financial services nonprofit sponsored in part by the United Way, estimates that about 35 percent of mortgages that are approved are unrealistic for consumers. What’s more: Many people “really trust the lender’s numbers and think that if they’re approved, they must be able to afford it,” Bishop says. But this isn’t always sound financial advice. Just because you can get approved for an expensive house doesn’t mean you should buy it.
Even with regulations in place, remember that banks are in the business of creating loans. Lenders “have incentives to give out mortgages, and to be positive and aggressive,” says Liz Miller, a certified financial planner and president of Summit Place Financial Advisors in New Jersey. Be skeptical and look out for your own interests. To avoid taking on more than you can handle, here’s what to keep in mind during the home loan process — and why you shouldn’t hit the top of your approved price range.
Lenders Don’t Have the Full Picture
A home is a totally unique purchase, Bishop says, because you need to consider not just what you can afford now, but what you can afford down the line. “None of us can predict the future, but we can plan for the next five to 10 years.”
While lenders work with the information that the consumer has provided, they don’t necessarily know the intricacies of a family’s financial picture — and how that might change in the future. You’ll need to account for changes like having children, as well as income fluctuations.
“Many people and lenders are planning as if everything goes perfectly,” said Miller. It’s your job to be realistic and skeptical, and leave yourself a cushion for the unexpected.
Don’t Assume Your Income Will Grow
On the other hand, in some ways banks are looking at the future when they approve your loan — but they’re looking at the best-case scenario. “Banks assume that income will grow over time,” Miller says. “They’re already working in the idea that you’ll make a lot more money in the future, but that is not how life always works.”
This is especially true for younger people who are not yet generating a large income but are following the guideline to spend 30 percent of your entire income on mortgage, taxes, and insurance. Homeownership can seem unachievable when 30 percent of an income realistically won’t cover all home expenses, Miller says.
In cases like these, the bank may lend more than the benchmark 30 percent, assuming that the family’s earning power will go up over time and that, as a result, the home will eat up less of their income. But this is a risky endeavor and can put strain on homeowners.
Although conventional wisdom used to be that real estate would always increase in value, the 2008 financial crisis showed that that’s not always true, Miller says.
“We used to say buy as much house as you can and grow into it, but now we say buy a home that you can afford,” Miller says. “Buy realistically right from the start. Don’t look at your home as something that will necessarily go up in value. Look at your home as somewhere you live.”
Read the Fine Print
Sometimes lenders will manipulate the terms of a loan so that the mortgage has lower payments in the beginning, making the amount seem more manageable to borrowers.
“Very low interest rate short-term mortgages, variable rates, balloon payment: these are phrases that a borrower may not fully understand,” Miller says. Instead of being wooed by these offerings, Miller says to analyze the cost of a home based on a 30-year, fixed-rate mortgage, which gives a more conservative and accurate picture of the cost over time.
See the Bigger Picture
When a large percentage of your income goes toward your home payments, you’ll have to cut back in other areas. But this isn’t a simple matter of not having money for splurges. “Making sacrifices in other areas of your life can impact your retirement and have far-reaching effects,” Bishop says. Spending outside your means can also hurt your quality of life. “The emotional hold that financial stress has on people when the budget is so tight can put strain on personal emotional outlook and relationships,” she says.
While legal regulations have led to crackdowns on predatory lending, it’s still ultimately up to the consumer (you) to determine an affordable mortgage for them, rather than taking the word of a lender.
Get a good understanding of your monthly budget, even if you don’t keep a formal one. Don’t be afraid to ask the lender for the specific amount, including the interest rate and taxes, that you’ll be paying each month for a specific property. If you’re still unsure about how much is a safe amount to borrow, talk to a financial planner who can look at your whole financial situation.
You can also take a page from the Perkinses’ playbook by gathering as much information as possible about the true cost of living where you plan to buy. In addition to getting exact numbers from their lender, Sarah and Brandon asked family members who lived in the area about their taxes and utility bills.
“A frank talk about finances made a huge difference in being able to know if this is a realistic number,” Sarah Perkins says. “Without that, it would have been harder to trust the mortgage broker. We knew what was manageable for us and we weren’t going to let anyone bully us into spending more.”