When applying for a loan, it’s a frequent occurrence to receive an approval amount outside of your budget. While your credit report may demonstrate to a lender that you could feasibly afford to borrow “x” amount, your household budget may not support that.
Unfortunately, with the larger number before you, it is tempting to borrow at the high end of your approval, as opposed to critically considering how much you can afford.
Particularly when shopping for large ticket items such as a vehicle or new property, the appeal of pushing your budget’s envelope by buying a more expensive home or car can overwhelm practical budgeting.
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While maxing out a loan approval for a car can be financially painful if mishandled, borrowing the maximum amount on a mortgage loan approval can be downright detrimental.
Quizzle had the opportunity to speak with two personal finance experts regarding mortgage approvals and borrowing.
Experts Recommend: Understand What Approval Means
Texas Tech University’s Department of Personal Financial Planning Director of Planning, President of the Financial Planning Association of West Texas and CFP® Eric Sawyer has over ten years of experience in the field, in addition to a background as board member with the Dallas/Fort Worth Financial Planning Association. In breaching the subject, Sawyer stated, “No matter how much we plan for, life will throw something at us to knock us down every so often.”
“If we don’t hedge a little,” he continued, “we risk unnecessarily creating larger problems.”
As an example, Sawyer shared, “I worked with a client who luckily did not buy a house with their maximum approval amount. Within a few short years of buying a house with a smaller mortgage, she lost her job. They were able to stay in their home because their mortgage amount was only based on her husband’s income.”
Rudd Family Foundation Professor of Finance for Berkeley’s Haas School of Business Dr. Terrance Odean commented, “There are many reasons not to buy a house for your maximum mortgage approval. For example, the house may be much larger and/or more expensive than you need.
“Or,” he continued, “you may be concerned about the leverage risk from buying an expensive house because you were able to borrow a large mortgage. Or you might be concerned that if you experience an income shock, e.g., lose your job, you won’t have enough emergency savings to continue paying a high mortgage.”
Odean, who is widely known for his research on behavioral finance, continued, “The fact that a bank is willing to lend you a large sum doesn’t necessarily mean that you should borrow a large sum.”
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Approved Amount Vs. Borrowed Amount
There is a widely accepted misconception that approvals not only justify, but almost necessitate borrowing the maximum amount. This line of thinking is dangerous and can lead to extensive financial troubles.
Beyond simply stretching your monthly budget too thin, Sawyer explained that unforeseen circumstances alone can justify not borrowing the full amount of your approval, “In addition, there may be unforeseen events, foundation problems, or other maintenance issues that come up causing a tight fitting budget to burst.”
Odean explained further, “To ensure that you can pay off the debt, buy a fixed rate mortgage with a monthly payment that does not overwhelm your monthly budget — even if the bank is willing to lend you more. The less secure your job, the less you should borrow and the more you should try to build up emergency savings.”
The Importance Of Maintaining An Emergency Fund
Elaborating on maintaining and revising emergency fund goals, Sawyer advised, “The first answer is don’t do this to begin with. If this particular home is that important, find other areas in your spending that are not as important and can be cut.”
Sawyer recommends to add to an emergency fund based on what major repairs might cost.
Variable Vs. Fixed Rates
Finally, both experts highlighted the importance of understanding the pros and cons of different interest rates.
Sawyer made it clear: “If someone insists on nearing the maximum mortgage amount allowed, a variable rate should be avoided at all costs.” He says that using a teaser or initially low variable rate to obtain a max mortgage is very risky.
“[That] won’t just make Lincoln scream. When rates go up, the hapless owners will too.”
Odean supported this idea. “The closer you are to your maximum ability to make monthly payments,” he said, “the more important it is to have a fixed rate rather than adjustable rate mortgage.”
It’s important to understand what you are getting yourself and your finances into when you apply for substantial loans. Talk with a financial planner or advisor about the process and what approvals mean for you and your budget.