All too often people apply for a mortgage without a comprehensive understanding of what their budget can handle. In fact, many mortgage and financial experts have cited this type of hasty mortgage buying behavior as one of the primary causes of the housing crash. More importantly, it's generally the reason that so many Americans are now "underwater" - meaning that they owe more on their mortgage than their home or property is worth. As a result, the first thing that a mortgage borrower should do - before they look at homes, make moving plans or fill out a mortgage application, is to conduct a thorough review of their budget and figure out exactly how much mortgage they can handle.
There are 4 critical components required in order to develop a budget and apply for the right mortgage:
1.) Comprehensive Financial Analysis
When most people think about their budget, they simply total their primary expenses; generally rent or mortgage payment, utilities, automobile payments and related expenses, and groceries. Then, they simply subtract the total cost of these expenses from their total monthly take-home salary, and the remainder is considered disposable income. But for most people, this is far from accurate.
The reason this is not an accurate way to analyze your finances is because for most people there is so much more involved that many just never think of- items that easily (and quickly) add up to thousands of dollars per year. This includes pet food and veterinary care, clothing, haircuts, daily small-store items like sodas and coffee, trips or outings, home repairs, cosmetics, car repairs, medical expenses, school supplies, credit card bills, insurance, and many other regular, often-unavoidable expenses.
So in most cases where a single person has $50,000 in income per year, they might think that their average expenses total around $25,000, leaving them capable of handling an additional expenditure for a mortgage. But when all of the above mentioned items are totaled, the reality of the situation is that there probably isn't much money left over at all.
Therefore the key to conducting an accurate financial analysis is to brainstorm all the things that you spend money on in the course of the month - no matter how insignificant, and do the math. This will give you a better idea of how much mortgage you can responsibly and comfortably handle.
2.) Create General Budget
Once you've detailed all of your expenses, creating a general budget is the next step. This may include dramatic changes in the way you spend money, especially if the detailed analysis above indicates that you're spending money in wasteful ways. The best way to build this budget is to prioritize expenses by a percentage of your income. For instance, most people allot 25% of their income to a mortgage or other housing expense/payment, and around 10% for a car payment.
Creating a budget based on percentages makes it much easier to plan a new or existing home purchase because you can quickly change the scope of the project and budget simply by changing the percentage. Unfortunately, too many people fail to properly budget for two critical items that we're listing as separate budgetary items because they're that important.
3.) Develop Disaster Budget
If you're maxing out your budget - meaning you can pay all of your bills every month but with no money leftover, then you're asking for trouble. Financial disasters happen to everyone from time to time, and in most cases people who ride the financial edge too closely suffer the most financial disasters. This means that you MUST reserve a portion of your budget for disaster planning. 5% is a good start, but 10% is obviously much better.
For example, consider the situation where you maxed out your budget and bought a beautiful new home. But then something happens - the motor seizes in your car or the hot water furnace in the house fails. If you have no disaster money, you won't be able to pay for either of these items unless you go further into debt, or cut expenses somewhere else. The trouble is that when most people max their budgets, there are few places that you could "cut" from. And when homeowners are unable to make repairs or fix problems and start juggling their bills, it's not long before the mortgage payment is past due and real trouble starts brewing.
A disaster budget is critical. If you don't have a disaster budget, you can't possibly know how much mortgage you can handle.
4.) Develop Savings Budget
A savings budget that is independent of your disaster budget is also a fundamental part of understanding what size mortgage will work for you. While not as critical as a disaster budget, the fact of the matter is that most people will not be able to comfortably retire on Social Security alone. Some other type of savings must exist in order to maintain your lifestyle once you retire. But if you max out your budget (or overextend it) you'll have no retirement fund and may have difficulty hanging on to your home once you're no longer earning the same amount of money. And because medical expenses increase with age, it's likely that your monthly expenditures could increase, further incapacitating your ability to maintain a mortgage or even a tax payment.
If you're under age 45, saving 5% of your income per year could significantly bolster your retirement fund if invested wisely. If you can save more it would be prudent to do so. People over the age of 45 would be wise to save as much as possible, starting in the range of 10%.
Please note that none of this information is meant to be construed as financial advice: it is merely used as examples to explain the overall process in determining how much mortgage you can handle. For many people, analyzing their budget and creating a long term plan that includes a new mortgage or refinance should involve a professional financial planner and advice from your local mortgage lender.