Large suburban home
Ken Davies / Getty Images

Applying for a mortgage is a rigorous process. You’ll be asked to produce a slew of information, including copies of pay stubs, W2s, bank statements, tax returns and child support — just to name a few.

When this detailed financial examination produces a loan offer, take a step back before you sign on the dotted line. Although a bank might be willing to lend you a pile of dough, it doesn’t mean you should accept the full sum.

Lenders are not considering your financial goals when they determine how much to lend you; instead they’re considering their risk and profit. The more you borrow, the more money they make. In some ways, the lender’s and borrower’s goals are at cross purposes.

“You can’t rely on banks to financial plan for you – banks are compensated on production. If you can qualify for a $1 million loan, but only need $500,000, the bank would just as soon as put you in the $1 million loan because they’re going to make more money,” says Steve Merrell, partner at Monterey Private Wealth in Monterey, California.

Create a financial plan before you even look at a house

If you find yourself window shopping for homes in your dream neighborhood before you’ve created a budget, you could be setting yourself up for trouble, warns Rebecca Kennedy, principal of Kennedy Financial Planning in Denver.

Imagine getting approved for a loan that covers your dream house — without considering your long- and short-term term goals first. For some, satisfying that desire now would overtake the bigger financial picture, such as having enough money for retirement savings, college funds and emergencies.

“Don’t get a mortgage so big that it doesn’t offer room for other goals,” Kennedy cautions. “It’s the most helpful if you can talk to a financial planner or at least come up with your own budget before you even start looking at houses. It’s hard to dial back once you have your heart set on something.”

Getting a mortgage that stretches your budget can be a costly mistake not easily corrected because buying and selling a house comes with hefty fees. These include closing costs, which range from 2 to 5 percent of the total cost of the house.

Once you sell, you’ll have to pay the agent’s commission — typically 4 to 6 percent of the home’s sale price. Most sellers also spend money on repairs and upgrades.

“Before you take out a big mortgage, have a strategy – is there something unique about the house that makes the cost justifiable? Too often people react emotionally to the situation and they don’t think it through,” Merrell says. “Take time to plan out how it all fits in your life and how that mortgage will affect all your goals.”

A solid financial plan should include how much you earn and how much you spend. Your expenses will include:

  • Retirement and emergency savings.
  • Fixed costs, which are bills that don’t change, like utility bills, student loan payments and insurance payments.
  • Variable expenses, such as entertainment and eating out.

Next, define your financial and lifestyle goals. Consider important life issues, like what your ideal retirement age is, whether you plan on having children, how you’ll pay for their education, and how much you can afford in mortgage payments if you or your partner loses their job.

Lifestyle goals might include travel and entertainment. If you prioritize eating out regularly, then that should be figured into your budget. For some people, owning a house that offers amenities like a pool and extra bathrooms outweighs things like annual vacations or new cars. You’ll want to carefully outline your wants versus needs and organize them according to how much you can afford.

How much you should spend on housing

Most financial experts agree that folks shouldn’t spend more than 30 percent of their monthly gross earnings on housing. For people who bring in $3,000 per month they should aim for no more than $900 in housing costs.

Those costs should include more than just a mortgage payment, Kennedy says. Homebuyers should also include property taxes, homeowners association fees (HOA) and insurance in that 30 percent limit.

“I think a conservative approach to budgeting is best. If you take out a big mortgage with a spouse or partner then you should also consider life insurance. You’ll still have to make those big loan payments if something happens to them. These are things people need to talk to their financial advisers about,” Kennedy says.

Finally, the cost of your house and, by extension, your mortgage will also dictate the size of your down payment. Kennedy recommends putting at least 10 percent down, that way you have some equity if the market softens.  Chris Hogan, financial coach and author of “Everyday Millionaires,” urges people to put 20 percent down in order to avoid private mortgage insurance, or PMI.

Borrowers who have less than 20 percent equity in their home are required by most lenders to pay PMI. This insurance protects the borrowers and helps them offset risk – but it can add $100 to $150 to your monthly mortgage payment.

If you have to dig deep into your emergency savings to come up with the down payment, then you might want to reconsider how much you’re spending.

One overspending trap some homebuyers fall into is comparing themselves with their peers. They might see their coworkers or family members living a certain lifestyle and feel pressure to keep up, but this is a mistake, Merrell says.

“You shouldn’t compare yourself to peers – you have no idea what their financial situation is actually like. They could be in deep debt with leases on all of their cars. Most people who live in those big, ritzy neighborhoods are in debt,” Merrell says.

The housing market in 2019 is expected to cool, so this might be a good time for homebuyers to start shopping. Before you fall in love with a certain neighborhood or house, however, be sure to talk to your financial adviser — this could help you avoid a costly mortgage mistake in the new year.

How to live below your means

Buying a house is part of a larger financial imperative, which is to create a budget that allows your money to work for you, Hogan says. By maxing out your income to pay for a mortgage, you’re shrinking your margin and exposing yourself to greater risk. Here are a few ways folks can practice living below their means to create a more solid financial foundation.

Don’t get focused on homeownership at all costs

From a young age, many people are told they must own a home. That refrain gets louder as they get married and have children, Hogan warns.

“People believe they have to buy a house because they’ve reached a certain age, but that’s not true. It’s actually okay to rent — especially if renting allows you time to get the right property and save 20 percent down,” Hogan says.

Build up a fully funded emergency account

If your house payment is too expensive to allow you to save and keep enough money to support you for three to six months, then you’re living above your means. When you budget for a mortgage, be sure to leave enough room for savings.

Know your spending habits

Spenders might be more tempted to get a larger mortgage, save less and buy more. This is a recipe for financial trouble. Don’t beat yourself up — just make it hard to spend the cash you worked so hard for. The first step is to avoid shopping for homes outside of your budget; this will lessen the temptation to get an oversized mortgage.

The next step is to look at houses that are substantially below your budget. It’s a trap to fall in love with houses you can’t or shouldn’t afford.

Use Bankrate’s calculator to see how much house you can afford.

Consider a 15-year mortgage

Knowing what your financial goals are and putting a plan together to make them happen is key when you shop for a mortgage. One of those goals should be to pay as little extra fees, such as interest and PMI, as possible.

Hogan advises homebuyers to get a 15-year fixed-rate mortgage, rather than the more common 30-year mortgage. You might have to sacrifice how big the mortgage is since your monthly payments will be more expensive, but in the long run you’ll save a mint in interest payments.

“It’s really about staying in control, and that starts with budgeting,” Hogan says. “Once you have a budget, you can make space for yourself so that you never have to reach for debt. That’s freedom.”

Learn more: