Deborah Harrison—Getty Images
By Tim Lemke / Wise Bread
March 11, 2015

It’s not uncommon to find yourself in need of a loan to pay for a home, car or other major expense. But navigating the world of lending can be a bit bewildering.

If you’re careful and sensible, it’s possible to borrow money without risking your financial well being. In fact, responsible borrowing can be an integral part of wealth-building. The key is to know how much loan you can actually handle easily. But, how do you determine this?

Know Your Credit Score

Your FICO credit score will play an enormous role in the size of the loan you can qualify for and the interest rate that you will pay. The higher the score, the better off you’ll be. Everyone is entitled to one free credit report each year through annualcreditreport.com, so be sure to examine it if you’re considering taking out a loan. A credit score above 720 usually qualifies you for good rates. Anything less than that, and you may want to consider taking steps to improve your score before borrowing. This means correcting any errors and paying down outstanding debts.

Learn About Debt-to-Income Ratios

The general rule of thumb regarding mortgage loans is to avoid dedicating more than 28% of your monthly take-home income to housing. This includes not just the mortgage payments, but also related taxes and fees, which can add another 2%-3% to the overall cost. So in other words, a person taking home $50,000 should avoid paying more than $1,166 per month toward their home. ($50,000 x 0.28 = about $1,166).

There’s another key factor, however, and that is your overall debt load. The 28% rule above applies to the mortgage loan itself, but financial experts advise having an overall debt-to-income ratio of no more than 36%. So if you already have other loans, you may want to take on a smaller mortgage, or paying them down before borrowing more.

What You’re Approved For Is Not Necessarily What You Should Borrow

When you apply for a loan, a lender will usually let you know how much you are approved to borrow. It’s best to ignore that number. Just because you are approved to borrow $500,000 for a home does not mean it’s wise to go and borrow $500,000. It’s nice to get approval, but banks found themselves in trouble a few years ago when they approved loans for amounts that were well beyond what the borrowers could comfortably afford.

Down Payments Are Key

If you can’t afford to buy a house or other big purchase in cash, at least put down as much money as you can. This will reduce the size of the loan and the amount of interest you will pay. A larger down payment could also make you more attractive to lenders, who can offer a more generous interest rate. When buying a home, a down payment of 20% or more will usually mean you can avoid paying for mortgage insurance.

Look at Loan Length, Not Just Monthly Payments

All too often, borrowers will focus on the monthly payments without looking at the total cost of a loan. The great car buying advice site Edmunds.com advises to keep loan terms to no more than five years, and reports that two additional years on a loan of a Honda Accord would add more than $3,400 in interest charges. Similarly, a 15-year mortgage on a home will save you tens of thousands of dollars over a 30-year term, even if your monthly payments are higher.

Future Income Is Not Guaranteed

I once heard a friend say that they planned to purchase a more expensive home than they could really afford, because they figured they’d be earning more down the road. This is a very risky approach to borrowing. A more sensible approach is to borrow based on your current financial situation, then any extra income you earn over time can go into savings or be used to pay off the debt earlier.

Don’t Steal From Your Future Self

Are you putting away money toward retirement? Would a mortgage payment or other loan prevent you from contributing to an IRA or 401(k)? If you’re making loan payments but are unable to set aside money for the future, then you may be borrowing too much. Set aside 10%-15% of your salary for retirement before seriously considering large loans.

Consider Future Expenses

A couple with no children might crunch some numbers and determine that they can comfortably afford a loan of a certain size, but will their monthly expenses always be what they are now? It’s important when borrowing to try and anticipate future costs, especially when exploring a long-term loan. A good rule of thumb is to assume that your costs will rise yearly with inflation (roughly 2%-3% a year; add more if you expect a larger family, or a move to a more expensive area.)

Read more articles from Wise Bread:

5 Loan Options for Those With Good Credit
Worried About Debt? Tips On Managing Your Loans
5 Strategies To Wipe Out Your Credit Card Balance

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