It can be hard to get a loan. Whether it’s a mortgage, a student loan, an auto loan, or even a credit card, getting a loan can be difficult. And there is a trap that many people fall into once they get the good news that they’ve qualified for the loan. They think the amount they qualify for is the amount they SHOULD borrow. If you take nothing else away from this, remember that what someone will loan you is NOT what you can afford to borrow.
Here’s a quick (simplified) example: you’re a first time home buyer and you go through the pre-approval process and find out you’re pre-approved for up to $300,000! That’s great news right? That means a $300,000 loan is right for you! No. No, no, no, no. That means the lender thinks that you can make the payments on a $300,000 loan. Generally speaking the bigger the loan, the more money the lender makes. They want to lend you the most money possible that they think you’ll pay back. And they know that since it’s your home that’s one of the payments you’ll prioritize.
The lender doesn’t care if you want to save up for a wedding, or a vacation, or to retire early, or for your kids’ college funds. They don’t care what your other goals are, they just care if you’ll pay back THEIR loan. If you have to cut back in other areas, put off retirement, or put expenses on a credit card but you still make your mortgage payments, the loan is working out great for them.
What you can afford depends on how the monthly payments fit into your overall budget and how much you want to pay in total over the life of the loan. And don’t forget the loan payments aren’t the only new expenses you’ll be taking on. If it’s a mortgage, remember there are maintenance costs, homeowner’s insurance, and property taxes. A car loan means paying for gas, maintenance, taxes and tags. You need to account for these too. The bigger the loan, the longer your decision here will affect you. It’s very very difficult to undo the decision to stretch your budget to the breaking point by taking on too big a mortgage, or buying too expensive a car. Those monthly payments are with you for YEARS.