When you apply for a mortgage pre-approval, your mortgage broker will ask you a series of questions about your financial situation. They’ll want to know the size of your down payment, your employment history, whether or not you have debt, as well as ask permission to pull your credit score.
Your mortgage broker will use this information to calculate your debt service ratios, which will help determine your affordability and the best mortgage rate you can get. They’ll factor in your down payment and will pre-approve you for a maximum amount.
But if you’re pre-approved for a certain purchase price, does that mean you should spend the full amount when buying a home? According to RBC’s 2016 Housing Trends & Affordability Report, Canadians are spending more and more of their pre-tax income on housing. But that doesn’t mean you should follow suit. Let’s take a look at the implications of using your full pre-approval amount and an alternative method to determine your maximum purchase price.
Understanding the limitations of a mortgage pre-approval
First, let’s be clear on what a mortgage pre-approval is: It’s your mortgage broker’s estimation of the most you can afford based on your current income and debt levels using industry standardized formulas.
A mortgage pre-approval doesn’t take into account your personal financial goals, extra expenses beyond debt payments (like child care), and saving for retirement or a child’s education.
Because of this, you may be pre-approved for a higher purchase price than your budget can handle.
What spending the full amount of your mortgage pre-approval looks like
Let’s look at an example of what spending the full amount of a mortgage pre-approval would look like, using my financial situation as an example.
I’m planning to buy a home soon and I was recently pre-approved for a mortgage. I have a down payment of $27,000. I also have an excellent credit score. My husband and I earn about $110,000 per year.
If we put 5% down and obtain a five-year fixed mortgage rate of 2.32% amortized over 25 years, a mortgage affordability calculator (which uses the same formulas mortgage brokers use) estimates I can afford a home worth $540,000.
If we were to buy a home worth $540,000, my monthly mortgage payment would be $2,285. After we include estimates for property tax, utilities, insurance, and communications, our housing costs will total $3,928 per month.
Assuming a tax rate of 30%, we have $6,419 available each month to spend.
Gross yearly income ($110,000) ÷ 12 months = $9,166 per month
Gross monthly income ($9,166) x taxes (30%) = $2,749
Gross monthly Income ($9,166) – taxes ($2,749) = $6,419 net income
If I plug the housing costs above into our budget, we’ll have about $2,491 left over each month to pay for everything else.
We could still afford to save for retirement, but we’ll have to cut back on grocery spending, entertainment, and travel. We also won’t be able to afford to save for a new car and we won’t be able to afford childcare if we choose to become parents in a few years. If we had to renew my mortgage at a higher rate in five years, our budget would be squeezed even more.
Now let’s look at a different way to determine how much you can afford to spend on a home.
What determining your maximum purchase price looks like
Instead of spending the full amount of your mortgage pre-approval, try building a budget that gives equal priority to your other financial goals. Factor in priorities such as saving for retirement, travel, and childcare as well as expenses like groceries, your car payment, and entertainment. Whatever’s left over is what you can afford to spend on a home per month.
In our case, we can spend about 35% of our net income on housing and still reach our other financial goals.
Using that 35% figure, we should only spend $2,245 on housing costs.
Net monthly income ($6,416) x 35% = $2,245
If we want to spend $2,245 on my housing costs including utilities, property tax, and insurance, and I’ve $27,000 saved for a down payment, I can use a mortgage payment calculator to determine that our maximum home price is $335,000. That’s $205,000 less than the mortgage pre-approval!
By purchasing a home priced below our mortgage pre-approval amount, we’ll have plenty of money left over every month to save for retirement, travel, and save for upcoming life expenses like renovations, replacing my car, and parenthood.
Looking beyond a mortgage pre-approval
On top of ensuring you can comfortably afford your housing costs today, you also need to estimate whether you can afford your housing costs in the future. Your mortgage pre-approval won’t take this into consideration.
Will you be able to afford your home if mortgage rates rise in the future? What if you add a child to your family and one parent has to take parental leave? What about daycare costs or the cost of caring for an elderly relative?
To accurately estimate whether you can afford a home at a specific purchase price, you should prepare mock budgets that take these future costs into account.
Receiving a mortgage pre-approval is an excellent way to lock in a mortgage rate, to find out if anything in your application is likely to cause problems, and to show sellers that you’re a serious buyer. But it won’t tell you how much you should spend on your home.
Only you can decide what works for your budget. Instead of spending the full amount of your mortgage pre-approval, create a budget that meets all of your financial priorities. Whatever’s left over is what you can afford to spend on a home every month.
By using this method, there won’t be any surprises and you’ll be comfortable with your budget for years to come—even after you become a happy homeowner.
- How Your Mortgage Pre-approval Can Help You Win a Bidding War
- What is a Mortgage Pre-approval?
- How I’ll Pay Off My Mortgage 10 Years Early (and You Can Too!)
Flickr: Bruce Guenther