Whether you’re buying your first home or your fifth, being approved for a larger-than-expected mortgage can be intoxicating. But qualifying for a big loan isn’t the same as being able to afford it — and you don’t want your biggest asset to ruin your finances.
Look at what happened during the Great Recession: Believing their homes would appreciate in value, many people borrowed more than they could handle. When their homes lost value instead, those homeowners were stuck with underwater mortgages—loans that exceeded their home’s worth. This made it impossible for many to refinance or sell their homes for a profit, and led to a flood of foreclosures.
Before you sign up for a mortgage, ask yourself how much house you can afford.
Many financial advisors and consumer advocates recommend that you borrow less than you qualify for. These are a few of the reasons why.
1. You’ll Lower Your Risk of Missing a Payment
If your housing costs are on the edge of what you can afford, “the odds of not being able to make payments in the event of an economic emergency or a job loss is much too high,” says Casey Fleming, a mortgage advisor with C2 Financial Corporation and author of “The Loan Guide: How to Get the Best Possible Mortgage.”
And missing a mortgage payment can have a domino effect on your finances.
“If you are at risk of missing a payment,” Fleming says, “you are at risk of being in default, risk of ruining your credit and risk of foreclosure, which would wipe out your investment in the home.”
To ensure that the home you’re considering is within your budget, take all housing costs into account, including your mortgage payments, property tax payments, insurance premiums, maintenance costs and, if applicable, homeowners association fees.
2. You’ll Be Prepared for Emergencies
Life can be rough. You might lose your job or face a medical emergency that drains thousands from your savings. You might have to move before you’re able to build significant equity in your home.
“Many people are on the razor’s edge when it comes to being able to tolerate any kind of economic disruption in their life,” says Brian Sullivan, a supervisory public affairs specialist with the U.S. Department of Housing and Urban Development.
Close to half of all American households don’t have enough savings to stay above the poverty line for three months if they lost their income, according to recent findings from the Corporation for Enterprise Development.
Getting a smaller mortgage than you qualify for will allow you to stash away extra money so you can handle hardships.
Experts advise keeping enough money in your savings to cover six months of living expenses. You should also be saving for life after retirement.
“If all of your money is going to your monthly housing costs, then you aren’t able to invest in your retirement accounts or other savings,” Fleming says. “The closer you are to the maximum qualifying [mortgage], the closer you are to having too little disposable income and inadequate reserves.”
3. You Can More Easily Afford Other Costs
Part of the fun of owning a home is filling it with things you want and need. If you have children, you might need to set aside money for college. And let’s not forget the costs of fixing a leaking roof or a busted water heater.
If you have to make other debt payments—say, on credit cards, or auto or student loans—it’s in your best interest to opt for a smaller monthly mortgage payment, and put your savings toward these expenses.
4. You Can Avoid Using Your Home Like an ATM
When less of your monthly budget is taken up by the mortgage, you’ll have more disposable income and be less tempted to use a cash-out refinance—the process of replacing your current mortgage with a larger one and pocketing the difference—to buy a new car or pay off credit card debt.
A cash-out refinance can be risky because you’re putting your home on the line. If you miss a few credit card payments, you won’t lose your home. It’s another story when you can’t make higher mortgage payments after a cash-out refi.
“A home is shelter first and foremost, as opposed to an ATM for wealth creation,” HUD’s Sullivan says.
5. You’ll Be Prepared If Property Taxes Rise
“You don’t know what will happen to property taxes in the future, which affect your mortgage payment,” says Lorraine Griscavage-Frisbee, deputy director of the Office of Outreach and Capacity Building at HUD.
Depending on where you live, property tax rates may increase annually.
“Many municipalities tie taxes on their properties to the current value of the home. If someone is maxed out on their mortgage payment, they may not have any wiggle room if next year the tax bill goes up because of appreciating property values,” Griscavage-Frisbee says.
6. You Can Decrease Your Risk of Having an Underwater Mortgage
Your home’s value isn’t guaranteed to increase over time. If it drops and you don’t have enough equity built up, you could end up owing more than the house’s market value, which is sometimes called having negative equity.
Over 4 million homes were in negative equity positions at the end of 2015, according to a report by real estate industry research firm CoreLogic. That’s an improvement compared with conditions immediately after the last housing bust, but Fleming says it’s still dangerous to count on home appreciation.
“If real estate values rise dramatically, it may work out well in the end, anyway, but it seems very dicey to put all your eggs in one basket. If it doesn’t work out, you could end up with no assets at all,” he says.
A Borrowing Rule of Thumb
So how much should you borrow? Your debt-to-income ratio—the percentage of your pretax income that goes toward mortgage and other debt payments—is one way to figure out how large your loan should be. Professionals say 28 percent is a safe target, though lenders often allow borrowers to go much higher.
You can also use a mortgage calculator to see what you might pay each month.
In some cases, it does make sense to borrow what you qualify for. If you have a high income, plan on staying in your home for at least seven years, are buying in a competitive market or have sky-high rent payments, there is some flexibility in the 28 percent rule.
But if you can go lower than 28 percent, you should. That way, you’ll be more likely to feel comfortable—financially and otherwise—living in your home.
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