However, before placing your final offer, consider what you may be looking at in several years in the future.
How much You can be Approved for?
When getting approved for a mortgage, the bank will calculate the maximum mortgage payment that you can afford to be, at the absolute maximum, approximately 40% of your annual income. To describe this in actual numbers let’s use the following situation:
Your Annual Income: $40,000
Interest Rate: 4%
Amortization: 35 years
Your Property Taxes: $200/month
You have no outstanding loans, lines of credits, car loans, credit cards, etc.
You could potentially purchase a property for $300,000
Now you will be thinking ‘wow, I can buy a great house with such a little annual income’; however, this is definitely not the case.
Albeit, the bank may approve your mortgage, but let’s compare your take home dollars versus your household upkeep:
Total Mortgage Payment: $1,456.28
Total Monthly Property Tax Payments: $200
Monthly Home Insurance Payment: $62.50 approximately
Monthly Utility Bills: $300/month
Monthly Food Bills: $5/day or $150/month
Transportation: $200/month
Entertainment and Communication: $100/month
Total Expenditures: $2,468.78/month
Total Income: $40,000
Taxes and Other Deductions: $8,698.58
After-Tax Income: $31,301.42
After-Tax Monthly Income: $2,608.45
This means that you have a monthly surplus of $139.67 when living on an extremely light budget.
What Happens if Interest Rates go up?
When first applying for a mortgage, the bank is more than happy to approve your mortgage with a financial situation like this, but when you analyze what will happen if interest rates go up, then if some major financial improvements have not been made for the borrower, then the borrower could be in big trouble. Let’s see what happens if rates rise 50% and 100%.
Mortgage Amount: $300,000
Mortgage Rate: 6%
Mortgage Payments: $1,695.76
Payment Increase: $239.48
Mortgage Amount: $300,000
Mortgage Rate: 8%
Mortgage Payments: $2,102.48
Payment Increase: $646.20
These are incredible increases, and it will cause the borrower to go from a surplus budget to a deficit in a short amount of time. This will cause the borrower to have to refinance the equity from the property to keep up with the payments, or the borrower will have to have an ever increasing income.
Don’t think that these rates can happen? Take a look at a Historic look at Prime Rate
Why would the Bank lend like this?
The bank lends like this because they are assuming that the property value will increase, and that the borrower’s income will increase with inflation. The loan is based on today’s dollars, while the future payments are based on future dollars. Although, it appears to be a large increase in payments with the change in interest rates, but the bank is hoping that a portion of their clients will be able to make the payments, some will have to refinance to be able to afford the property, and a small percentage will default on the loan.
Even though some of the borrowers default, the bank is still expecting that the property values have increased, so they can sell the property at a profit.
Protect Yourself from Perpetual Debt or Default
By purchasing a house that has mortgage payments that are well within your means is a great way to prevent either of theses situations. By applying the additional surplus that you will have against the principle balance of your mortgage, then you will be able to pay your mortgage off quicker. As you pay down your mortgage, then you will be able to get away with lower monthly payments. In a few short years, you will be able to upgrade your property to a much bigger property with fairly low monthly payments as well.
By keeping your mortgage balance low, your payments low, and your budget surplus high, then you will be able to get debt free faster, and have more money to buy the home of your dreams without the risk.
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