Rainbows and Unicorns: What lenders really mean when they say "affordable"

The point of this post: it's your job as the borrower to figure out if you can actually afford the mortgage the bank says you can.

When you think about how much money you make, do you use made up numbers or real ones?

If you think that's a strange question, then you've never applied for a mortgage, or you weren't paying attention when you were in the lender's office.

When banks and brokers talk about your ability to "afford" the mortgage you're applying for, they are using the word "afford" the way Vizzini uses the word "inconceivable" in The Princess Bride.

Read: they're using it wrong.

"Afford" (to the lender) means you are using 40% or less of your gross income to pay for your principal, interest, and property taxes, and to make minimum payments on all of your other debt.

"Afford" also means that you're using no more than 32% of your gross income to pay for your principal, interest, property taxes, and heating.

The last - but most important - thing the bank means when it talks about "affording" a mortgage payment is the interest rate. If you are in the market for a fixed interest rate of at least five years, the bank will base your minimum payment on the five year discounted rate that they're offering you. That means that right now, with some banks offering a historically low five year fixed rate mortgage at 2.99%, your ability to afford a mortgage for the next twenty-five years is based on a fixed rate that is lower than it's ever been.

Ever.

Before I break down those numbers a bit and maybe even give you an example, I need to tell you this: in my banking career, I was (often) in the position of telling people that - according to the bank - they could afford a mortgage payment that sounded crazily high to them. I was also (very often) in the position of telling people that - according to the bank - they couldn't afford a mortgage payment that sounded crazily low to them, but that's a story for a different day.

So let's take a look at some applicants who can "afford" the mortgage they're applying for:

Case Study: The Roberts Family

Westley and Buttercup Roberts need a bigger house than the one-room peasant shack they're renting now, and together, they bring in $6,325 a month before taxes or deductions. Their only debt is the minimum payments on their credit cards, their car payment, and the last little bits of Buttercup's student loans, which total $600 per month. They've painstakingly saved up a $25,000 down payment from their pirating and cow-herding jobs.

This means that, according to the bank, Westley and Buttercup can "afford" to purchase a $370,745 home and carry a $1,711 monthly principal and interest payment.

What the bank is thinking:

The bank came to this crazy conclusion by calculating 40% of Westley and Buttercup's monthly income, subtracting $800 to account for their monthly debt obligation and future property taxes, and by assuming that they will put 5% down and purchase the current five year fixed rate of 2.99% over 25 years. They ran the same calculation using 32% of the Roberts' monthly income, and subtracting only the property taxes and assumed $65 per month heating bill.

What Westley and Buttercup should be thinking:

As smart people, Westley and Buttercup immediately hear the number $1,711 and laugh. They know that $6,325 isn't a real number, and that their actual take home pay is $4,420 after taxes and employer deductions.

They realize that mortgage rates will eventually go up, and that it's more than possible that - come renewal time in five years - their mortgage payment will increase by $300 or so per month.

They know the cost of food, insurance, utilities, maintenance on their car and home, and other necessary spending will only increase over time. They are painfully aware of the fact that they're only making minimum payments on their credit cards and therefore paying 19% interest. They understand that their car payment will never actually go away without serious effort.

They even have the foresight to realize that eventually they want to have children, that parental leave is great but cuts your income in half, and that the cost of daycare if neither of them are able to stay home will easily cost upwards of $800 every month.

So what's the right number, then?

Rob Carrick at The Globe and Mail suggests that banks start using the "Total Debt Servicing + Savings Ratio", meaning that you can "afford" a mortgage payment only so long as you are able to pay it, your property taxes, the minimum payments on your debt, and save 10% of your income without exceeding the 40% of your pre-tax income threshold.

That would reduce Westley and Buttercup's maximum affordable mortgage payment to $1,451, which translates into a home price of $315,000 - $330,000 depending on how much of their $25,000 down payment they use (and that's another whole post for a whole other day).

Lenders will never, ever use this calculation, because it will result in fewer mortgage sales for lower numbers. Their pot of gold is at the end of the rainbow that the unicorns are frolicking under, and don't you forget it. It's up to you to translate their "affordable" into the land of reality - where taxes, daycare, insurance, and all those other mundane things live.

I guarantee you that going by the bank's number will max you out in every possible way. It will mean you pay more in interest, time, and stress than is healthy for your bottom line, your mental health, and your relationships.

The only way to calculate if a mortgage payment is really, truly affordable for you is by tracking and diligently planning your spending over time. It means exercising your discipline and self-knowledge, and it can be hard work, but blithely going along with the bank's version of reality is harder work in the long run.