Buying a home is a big deal, but going in unprepared can put you at a big risk of overextending yourself and getting too big of a mortgage. All else aside, the size of your mortgage and your bottom line should come first when it comes to buying a home. Lenders assess your affordability, but they don’t take all of your expenses into account so even though you’re approved for a certain amount, you can find yourself stretched too thin. But where is the line, and how do you know if you’ve overextended yourself?
How much should your mortgage be?
Let’s start with the obvious: if you can’t pay your bills each month, then you can’t afford your lifestyle. But when it comes to determining whether or not it’s your mortgage payments that are the problem, you need to take a harder look.
You may not have known this before getting your mortgage, but the general rule of thumb is that your housing costs shouldn’t account for more than 32 per cent of your gross household income. Lenders calculate this percentage by looking at your debt ratios
– how much consumer debt you have, other loans, child support and/or alimony payments, etc. They don’t take into account your other must-pays, such as transportation costs, child care, or insurance payments. So while you could pass a lender’s test when it comes to debt ratios, you still could be stuck with a mortgage you can’t afford.
Sarah Albert, president of PropertyGuys.com Mortgage, says that first-time buyers are more susceptible to overextending themselves than more seasoned home buyers who know what to expect, from the true cost of maintaining a home to legal fees involved with the transactions.
“It’s all about experience. That’s why first-time buyers love brokers. We talk to them so much about all of these other things. It’s not walking in and saying, ‘you can afford this maximum payment,’ Albert says. Instead, it’s ‘you can afford this maximum payment – but you should never do that.’”
Albert says that most of the first-time home buyers that they see being tempted to overextend themselves are the buyers who are in markets with higher purchase prices. Because they just want to get into the market, the buyers in these areas may only think of the mortgage payment, as opposed to everything else that their budget must include.
“They’re coming to us with purchase expectations that are too high, but it’s because they don’t fully understand,” Albert says. “These are folks that have been paying rent for years and they don’t understand that it’s not just the mortgage payment. It’s the property taxes. It’s the heat, it’s the repairs, it’s condo fees, it’s all of the unexpected things. So to put a first-time buyer at a 40 per cent debt ratio – I know we’re allowed to, but I think it’s just the wrong thing to do.”
For a lender’s consideration, property taxes are included as part of the affordability calculation, but things like annual maintenance and repairs are not. Repairs can be costly and, when found, need to be taken care of sooner rather than later. If you can’t afford to pay for them, then you know you have too big of a mortgage. If you also find yourself putting off necessary home maintenance because you can’t afford to do them, then you know that your mortgage is too big for you and that you have more home than you can afford. Home maintenance is like your health: an ounce of prevention is worth a pound of cure, and if you push off the necessary maintenance, you’ll have more costly repairs down the road.
Another red flag that you’ve overextending yourself with your mortgage is if you have less than 10 per cent equity in your home. Obviously equity doesn’t build overnight; in most well-balanced housing markets, it'll take about five years before you have enough equity in your home that you could break even or maybe make a profit if you wanted to – or had to – sell your home, after the remaining mortgage debt and transactions are paid off. But the less equity you have in your home, the less freedom and flexibility you have. Equity also gives you options when it comes to things like financing a home renovation, since you can use the money from the equity in your home.
Manage your expectations
While the same general parameters for debt ratios are used by lenders across the country, individual buying situations vary in each housing market. And what’s true for younger buyers may not be true of older buyers, regardless of whether or not they’re new to the housing market. A lot of first-time buyers, for example, are at the beginning of their careers and have a lot of income potential. But while the assumption is their incomes should increase, there's no guarantee that they will, and one surefire way to overextend yourself is to try and get a mortgage based on money that you don't have yet. In some housing markets, it's hard for buyers to face up to that reality that keeping those debt ratios as low as possible means being unable to buy a home – at least not the one that they want.
“In some of our larger, more expensive city centres, they don’t like to hear it because it means they can’t even be in the market. I find that’s the hardest thing, is to curb that expectation,” Alberts says.
One way to put theory into practice is to study two scenarios, Alberts says: one that looks at buying a home today based on your current income and lifestyle, and another based on your current income but taking into account things that may be coming up in their life such as an engagement, a marriage, and/or a child. The realities of the two budgets can be quite striking, serving as a shock to buyers who are at risk of overextending themselves. Alberts also likes to show buyers how much equity they’ll have in five years, as well as how much “step-up” income they’ll have at that point if they want to move into a bigger home.
“I find it really helpful to put it in front of them in actual numbers,” she says. “It’s, ‘here, look at these numbers and fill out this budget and tell me how you feel about this. How would you feel if you can’t meet your friends for supper on a Friday night to have craft beer? because that might bother you, and that’s what will happen if you go to a 40 per cent debt ratio.'”
While there are people who overextend themselves, there are many home buyers who take advantage of the mortgage apps, calculators, and other home buying resources and financial tools available to understand how buying a home can fit into their overall financial plan, not be a detriment to it.
“I think that our younger generation is quite smart and they really do like their lifestyle. And I think that there’s a shift coming where there’s more responsible borrowing than ever,” Alberts says. “Five years ago, more people came to me with just, ‘I want to buy a house and I don’t have a clue what the next step is.’ I find today, with everything that’s happening in the news, with the different tools that are online with the different apps, these guys are coming to us with some idea.”
It can be tempting to stretch your budget, but you don’t want your mortgage to be stressful in the long run. Have a frank conversation with your financial planner mortgage broker to determine a road map so that you don’t overextend yourself to get into a home.
How much can you afford to borrow?
Saving for a down payment may be a challenge for first-time buyers
Are you looking to invest in property? If you like, we can get one of our mortgage experts to tell you exactly how much you can afford to borrow, which is the best mortgage for you or how much they could save you right now if you have an existing mortgage. Click here to get help choosing the best mortgage rate