Saturday, May 28, 2011

Buying a house : mortgage

HyperSmash
How much house can I afford?  If you’re thinking about buying a house, the question of a mortgage is probably occupying your thoughts right now.  You’re wondering how much money a traditional lender (like a bank) will give you—and what information will be used to get that figure?

The second part of that question is easy to answer.  They will use everything they can obtain about your finances:  Factors will include your income and recent income tax returns, existing debt service, and credit score.  (Your credit score will also significantly influence your interest rate; a high credit score should make you eligible for lower interest.)  They may also want to review your spending patterns and how often you change jobs and residences.  (They are looking for reliability and stability.)  —Here’s something that may surprise you:  Lending institutions do not favor people who have a lot unused credit.  They are concerned that it will be abused in the future.

If you cannot supply the required information, it is quite possible you will be denied a mortgage for just that reason.  Neither does having all the figures guarantee approval.  The lending institution will see how your financial profile fits within a set of “rules” that determine how much of a mortgage you can afford (and that, for all practical purposes, defines how much house you can buy).

The rules are actually a set of percentages (of your gross income—that’s your income before taxes are taken out) used to figure the maximum you would be offered as a mortgage loan.  Although some lenders allow a very small variance, if your percentages are greater than those of the rules it’s becoming standard to offer you less (and perhaps at a higher interest rate) or, quite possibly, decline your application.

There are three rules (all based on maximum considerations).  The following is a summary of these rules:

1)      Monthly Mortgage Payment—The Rule of 28:  Your monthly mortgage 
payment should not be greater than 28% of your gross monthly income.
This number is simple to figure:  Divide your gross annual income by 12
and multiply your answer by 28%.  So, if you have a gross annual income
of $60,000 your mortgage payment should not be greater than $1,400
(60,000/12 = 5,000 x .28 = 1,400).

2)      Total Monthly Housing Payment—The Rule of 32:  The monthly average of all bills directly related to your housing payment should not be greater than 32% of your gross monthly income.  In addition to your mortgage payment, these are bills associated with housing—any mortgage insurance, homeowners insurance (including insurances covering specific occurrences like flood or hurricane), property taxes and HOA fees.  (This is where lenders may allow that small variance I mentioned earlier.  Some will allow 33% for these bills.) Based on a gross annual income of $60,000 your average monthly bills related to and including your mortgage need to be no greater than $1,600—certainly no more than $1,650.  And yes, a few dollars does make a difference to a lender.

3)      Monthly Debt Service Payment—The Rule of 40:  The required minimum monthly payments for your outstanding debts may not be greater than 40% of you gross monthly income.  This includes your mortgage and related bills, loans of any type—student, auto, etc.—and credit card payments.  (This explains why lending institutions do not want you to have much unused credit.)  Note:  This figure does not include utility bills.  (They are usually accrued and paid in full, cyclically.)  Based on that gross annual income of $60,000 with a monthly gross income of $5,000, at 40% your total monthly debt service should be no greater than $2,000—and of course the majority of that will be dedicated to housing.

Thinking about that Rule of 40 can be a bit deceptive.  Using the figures I’ve given you, $5,000 minus $2,000 leaves $3,000—right?   No, it does not.  Since the $5,000 indicated is gross monthly income, taxes and other deductions have to come out as well as all your living expenses—food, utilities, fuel, car maintenance, insurances (car, health, life…), savings, entertainment...  The list is practically endless.  Your money is not.  Lending institutions want to offer you the largest loan they can.  Your figures may make the maximum prohibitive.  Regardless, you may want to consider (1) reducing your monthly bills and (2) reducing the amount of money you want borrow.  This may mean reducing the amount of house you buy, but living better in it.  Or, you could wait to buy until you have large down payment.  The bank will give you as much money as its policies allow in order to make as much money as they can on the interest you pay.  You don’t want buying a house to lead to financial hardship.  You want to get a mortgage that will allow you to feel good in the house you buy.

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