Christopher M. England’s Outsourcing the American Dream
Protect Your Dream Home
How Much
Mortgage Can You Really Afford?
My dream is that we get back to what our Founding Fathers
intended for our country – life, liberty, and the pursuit of happiness. Thomas
Jefferson borrowed this treatise from English philosopher John Locke. Only John
Locke originally called for life, liberty, and the pursuit of property. Every
American should have the opportunity to own property and to invest in our
nation’s future.
No question about it, home ownership pays
dividends. Home ownership can be a sign of independence and success. Mortgage
interest and property taxes are tax-deductible. You build equity over time
which can be used the same as cash. But can you really afford it?
Before you start shopping for a new home, take the
emotion out of it. Sure you want that beautiful home in that safe neighborhood
with access to those top-notch schools. But
what good does it do to hunt for a $300,000 house when you cannot afford to go
above $225,000? Shopping for a home within your budget can save a lot of
heartache now, as well as down the road.
Caution:
How much you “qualify for” and how much you “can afford” are different
For starters, a good real estate agent should be
able to help you determine how much mortgage you can really afford, and he
should be able to put you in touch with reputable mortgage lenders.
When applying for a mortgage, there are several
criteria mortgage lenders use to determine how much they will allow you to
borrow. That is, if they’re reputable lenders. They’ll look at your credit
score; employment and income verification; existing assets, including cash;
existing car leases or loans, credit card balances, debt consolidation loans, home
equity loans, installment loans, student loans, and other on-going monthly
debts; and the size and source of your down payment.
Reputable lenders check your qualifying ratios to
verify how much mortgage you can really afford. More importantly, they do not
steer you toward unnecessarily-risky loan products.
As a
general rule of thumb, your house-hunting budget should not exceed 2.5 times
your gross (pre-tax) annual income. As an
example, a family earning $90,000 annually should try to restrict their
housing-hunting budget to $225,000.
Your Housing Expense Ratio (principal, interest,
taxes, and insurance, or PITI) should not exceed 25% to 28% of your gross
monthly income for conventional loans. Your Total Debt Ratio (PITI plus other
long-term debt) should not exceed 33% to 36% of your gross monthly income for
conventional loans. Other long-term debt includes car leases or loans, credit
card balances, debt consolidation loans, home equity loans, installment loans,
student loans, and other on-going monthly debts, including alimony and child
support. Unfortunately, to make a sale, lenders do not always adhere to these
qualifying ratios. As a result, many would-be homebuyers are misguided into
believing they can afford a much bigger mortgage than they really can. To make
matters worse, some government-sponsored loan programs (e.g., FHA) allow
homebuyers to stretch the Housing Expense Ratio from 28 to 31%, and the Total
Debt Ratio from 36 to 41%. Typically, loans that exceed conventional qualifying
ratios are designed to fail, resulting in higher mortgage delinquencies and
foreclosure rates. This problem is exacerbated by abusive or predatory lending
practices.
Let’s run through a qualifying scenario for the
family mentioned above. Using the conventional qualifying ratios, the maximum
Housing Expense Ratio the family can qualify for is $2,100 monthly; however,
down payments, homeowner’s insurance, interest rates, and property taxes
ultimately will determine how much the family really can afford to invest in
the mortgage itself, as will personal comfort and preference. If the family
assumes a $225,000 mortgage with a 30-year fixed rate of 6.25%, the resulting
monthly payment for principal and interest will be $1,385. Let’s assume
property taxes of $272 a month and homeowner’s insurance payments of $47 a
month. This brings housing expenses to $1,704 per month, excluding private
mortgage insurance, well within the qualifying parameters. Although within the
parameters, this probably is more than the family really can afford to spend.
Do they want to purchase that new boat they’ve had their eye on or travel to
exotic places? Do they want to save for their children’s education or for their
own retirement? How much does the family want to spend on new appliances,
carpet, furniture, etc. for the new home? What about adding a deck or finishing
the basement? How much do they want to set aside for savings and investments?
How much will the family need for gasoline and car maintenance and repairs?
What other long-term debts do they need to pay off? Will they need emergency
funds? After all, bigger, more expensive
houses lead to higher expenses for maintenance and repairs, property taxes, and
utilities. What about medical expenses? The family may want to dust off the
calculator or spreadsheet and exercise common sense and fiscal restraint. In
any case, the maximum Total Debt Ratio the family can qualify for is $2,700 per
month. With a current housing expense of $1,704, the family’s other long-term
debts cannot exceed $996 per month. Can the family keep their car leases or
loans, credit card balances, debt consolidation loans, home equity loans,
installment loans, student loans, and other on-going monthly debts below $996
per month? Again, this probably is more than the family really can afford to
spend.
What about down payments? When considering how much
cash the family will need for a down payment, they cannot forget to factor in
closing costs and private mortgage insurance. Closing costs typically run 3% to
6% of the purchase price. Additionally, they will need a down payment of 5% to
20% of the purchase price to avoid paying for costly private mortgage
insurance, depending on the lender’s preferences. Finally, most lenders will
recommend the family keep at least three month’s worth of principal, interest,
taxes, and insurance in savings at all times, something that will not be easy
to do if they are running at the upper limits of the qualifying ratios.
Avoid Lending Gimmicks,
Pitfalls, & Traps
Here are a few lending gimmicks, pitfalls, and
traps you will want to avoid:
“Your mortgage payment will not increase.” Say
what?! How can a $300,000 house not cost more than a $225,000 house? Use
common sense. If it sounds too good to be true, it probably is.
“It’s a new
build. We don’t know what the property taxes will be in years two or three.”
Say what?! With a new build, your property taxes will be significantly lower in
the first year of ownership than they will be in years two or three. An easy
way to estimate your property taxes for years two or three is to look up
similar-priced houses on the MLS – your real estate agent should be able to
provide this information to you.*
“It’s a 2-1 buy-down – your interest rate will be 4.5% the first year, 5.5% the second year, and 6.5% for the
third and subsequent years. Don’t worry about the interest rate moving
up in the second and third years. Your income will keep pace with increases in
your mortgage payment.” Say what?! For starters, never assume your income will
keep pace with rising mortgage payments. This philosophy should be applied not
only to buy-down loans, but to other loans designed with initially lower
“teaser” rates. Will you be able to handle the increased mortgage payments when
your ARM re-sets to a much higher interest rate?*
“There’s a pre-payment penalty.” Say what?! Bottom
line: never agree to this, no matter how excited you are about getting the
loan. You should never sacrifice the opportunity to accelerate payments to
principal, saving significant interest over the life of the loan.
“This is a “no-doc” loan. We don’t need to verify
your employment or income.” Say what?! You’re not concerned about what I do for
a living? That would explain some of my neighbors. You’re not concerned about
whether I can really afford this house? To
make matters worse, some lenders have gone as far as altering loan applications
just to make a sale!
“We use our own appraisal service.” Say what?! If
the builder’s own affiliated or in-house mortgage lender is using its own
appraisal service, how can the appraisal
be objective? While intentionally overstating the value of a home on an
appraisal is illegal, too many homebuyers end up paying far more for their new
home than is necessary. Insist on an independent third-party appraisal.
“You don’t need an attorney.” Say what?! Not having
an attorney check out the mortgage lending paperwork can be costly. Is it worth
paying an attorney $150 to $350 to review the paperwork on a $225,000 loan? Yes!
“You should refinance to reduce your monthly
payment.” Perhaps. If you have an ARM or other loan
designed with initially lower “teaser” rates that will re-set within the year,
refinancing definitely should be considered. For more conventional loans, a
common rule of thumb is you should consider refinancing if you can lower your
mortgage interest rate by at least 2%. In reality, it’s a little more complex
than that. Say you’re seven years into a 30-year mortgage, and you pay $4,000 in
closing costs or fees to refinance and lower your monthly payments by $200. On
a straight-line basis, it will take 20 months just to break-even on your
closing costs or fees ($4,000/$200.) Additionally, you just
re-set the life of your mortgage back to 30 years, meaning you could end up
paying significantly more interest over the life of the loan than you would end
up paying if you just stuck it out with your current loan (23 years remaining.)
Again, it’s necessary to dust off the calculator or spreadsheet.
*Ultimately, property tax and
interest rate increases are the primary reasons many homebuyers receive
mortgage sticker shock after the initial years of homeownership. The home they
could afford in the first few years simply isn’t affordable any longer. Protect
your dream home – insist that the lender calculate your qualifying ratios based
on the second or third years of homeownership. Above all, exercise common sense
and fiscal restraint.
Christopher M. England, a finance and
marketing professional, is an accomplished management and process improvement
consultant. His audiences range from senior executives to middle managers, from
seasoned professionals to entry-level support staff. He has an MBA in
Organizational Leadership and Management and resides in
Outsourcing the American Dream (ISBN
0-595-20148-2) is available for order wherever fine books are sold, including
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