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a certain down payment to protect itself against the possibility that you may default on the loan. Should you default on an auto loan, for example, the lender has to send the repo man out to take away and sell your car. This process takes time and money, and the lender will surely get less for the car than the amount that you paid for it.

      Much of the same logic applies to a home purchase with one important difference — over time, your home should hopefully appreciate in value whereas a car most definitely will not.

      In this chapter, we help you determine what you can comfortably afford to spend on a home as well as how to calculate how much a particular home is likely to cost you.

Lenders Can’t Tell You What You Can Afford

      

Ultimately, a lender doesn’t care about you, your financial situation, or your other needs as long as it has protected its financial interests. This is true whether you’re borrowing to buy a car or a home. The lender doesn’t know or care whether, for example, you’re

       Falling behind in saving for retirement

       Wanting to save money for other important financial goals, such as starting or buying your own small business

       Parenting a small army of kids (or facing steep private-schooling costs)

       Lacking proper personal insurance protection

      And therein lies the problem of making your decision about how much home (or car) you can afford to buy on the basis of how much money a lender is willing to lend you. That’s what Walter and Susan did. They set out to purchase a home when Walter’s business was booming. They were making in excess of $200,000 per year.

      Walter and Susan really wanted to buy the biggest and best house that they could afford. When they met with their friendly neighborhood banker, he was more than willing to show them how they could borrow $900,000 by getting an adjustable-rate mortgage. (You can read all about these mortgages in Chapter 6. We’ll simply tell you here that because some adjustable mortgages start out at an artificially low “teaser” interest rate, they enable you to qualify to borrow a good deal more than would be the case with a traditional, fixed-rate mortgage.)

Walter and Susan bought their dream home with an adjustable-rate $900,000 mortgage. Within a few years, Walter and Susan’s dream home turned into the Nightmare on Oak Street. Their mortgage became a financial noose around their necks.

      When blessed with young children, Walter and Susan didn’t want to work such crazy long hours; yet they were forced to do so to meet their gargantuan mortgage payments. The initial payments on their adjustable-rate mortgage were low, but they ballooned gigantically as the loan’s interest rate increased.

      The financial strain led to personal strain as Walter and Susan had frequent arguments about money and childcare. We know of others who stretched themselves the same way that Walter and Susan did. Many of them continue slaving away long hours in jobs they don’t like and making other unnecessary sacrifices, such as limiting the time they spend with family, in order to make their housing payments. Some end up divorcing, due in part to the financial strains. Others default on their loans and lose their homes and their good credit.

      

People at all income levels, even the affluent, can get into trouble and overextend themselves by purchasing more house than they can afford and by taking on more debt than they can comfortably handle. Just because a lender or real estate agent says you’re eligible for, or can qualify for, a certain size loan doesn’t mean that’s what you can afford given your personal financial situation. Lenders can’t tell you what you can afford — they can tell you only the maximum that they’ll lend to you.

The Cost of Buying and Owning a Home

      Before you set out in search of your dream home, one of the single most important questions you should answer is, “What can I afford to spend on a home?” To answer that question intelligently, you first need to understand what your financial goals are, what it will take to achieve them, and where you are today. If you haven’t yet read Chapter 2, now’s the time (unless you’re 100 percent sure that your personal finances are in tiptop shape). In the following sections, we dig into the costs of buying and owning a home.

      Mortgage payments

      In Chapter 6, we discuss selecting the best type of mortgage that fits your particular circumstances. In the meantime, you must still confront mortgages (with our assistance) because mortgages undoubtedly constitute the biggest component of the total cost of owning a home.

Start with the basics: A mortgage is a loan you take out to buy a home. A mortgage allows you to purchase a $200,000 home even though you have far less money than that to put toward the purchase.

      With few exceptions, mortgage loans in the United States are typically repaid over a 15- or 30-year time span. Almost all mortgages require monthly payments. Here’s how a mortgage works. Suppose that you’re purchasing a $200,000 home and that (following our sage advice, appearing later in this chapter) you have diligently saved a 20 percent ($40,000, in this example) down payment. Thus, you’re in the market for a $160,000 mortgage loan.

      You sit down with a mortgage lender who asks you to complete a volume of paperwork (we navigate you through that morass in Chapter 7) that dwarfs the stack required for your annual income tax return. Just when you think the worst is over (after the paperwork blizzard subsides), the lender proceeds to give you an even bigger headache by talking about the literally hundreds of mortgage permutations and options.

      Don’t worry — we can help you cut through the clutter! Imagine, for a moment, a simple world where the mortgage lender offers you only two mortgage options: a 15-year fixed-rate mortgage and a 30-year fixed-rate mortgage (fixed-rate simply means that the interest rate on the loan stays fixed and level over the life of the loan). Here’s what your monthly payment would be under each mortgage option:

       $160,000, 15-year mortgage @ 4.75 percent = $1,245 per month

       $160,000, 30-year mortgage @ 5.00 percent = $859 per month

      As we discuss in Chapter 6, the interest rate is typically a little bit lower on a 15-year mortgage versus a 30-year mortgage because shorter-term loans are a little less risky for lenders. Note how much higher the monthly payment is on the 15-year mortgage than on the 30-year mortgage. Your payments must be higher for the 15-year mortgage because you’re paying off the same size loan 15 years faster.

      But don’t let the higher monthly payments on the 15-year loan cause you to forget that at the end of 15 years, your mortgage payments disappear, whereas with the 30-year mortgage, you still have 15 more years’ worth of monthly payments to go. So although you have a higher required monthly payment with the 15-year mortgage, check out the difference in the total payments and interest on the two mortgage options:

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Mortgage Option	Total Payments	Total Interest
15-year mortgage	$224,064	$64,064
30-year mortgage	$309,312