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Assess Your
Finances
There's
no point wasting time and energy house-hunting before you
know what you can afford. So your next step is to assess
your finances:
Does it Pay to Buy a Home or Simply
to Rent?
If, like
most first-time buyers, you are presently renting, it's easy
to calculate your cost - simply, the monthly rent you pay.
(Utilities, phone, cable, and other costs can be ignored in
this comparison because they'll be approximately the same
whether you rent or buy.)
Use our
Rent vs. Buy Calculator to help you evaluate whether homeownership
is a sound financial option right now.
But calculating
the cost of homeownership is much more complicated, because
income tax considerations affect your bottom line. And there
is, in addition, the uncertainty about how much the value
of your home will rise (or even fall) in the coming years.
As a tenant,
you may be taking a standard deduction on your income tax
return. This is the time to judge how that standard deduction
stacks up against the amount you'd be able to subtract from
income if, like most homeowners, you itemized deductions instead.
Once you
itemize, you can deduct:
- Home mortgage interest;
- All real estate taxes on any
property you own;
- Your state income taxes;
- Charitable contributions;
- Medical and dental expenses
that exceed 7.5% of your income;
- Personal property taxes if
your state has them; and most important
- Certain moving expenses.
At the
start of a mortgage repayment schedule, when the debt
hasn't been reduced yet, almost all of your monthly payment
goes toward interest. A bit goes toward reducing principal
(the amount borrowed), so that the next month you're borrowing
a bit less, and owe a little less interest. That allows more
of your next payment to go toward reducing principal. However,
this process is very slow in the beginning and the interest
portion remains high for many years.
Between
the mortgage interest and the property tax deductions,
you can figure that Uncle Sam is shouldering part of your
monthly mortgage payment - 28% of it, in fact, if that's your
tax bracket. Your state income tax bracket can also be added
to that, before you calculate how much you save on income
tax as a homeowner.
Interest Rates and How They Change
As you
start shopping for a home loan, your first question of each
lender will probably be "What's your interest rate? How
much are you charging?"
Interest
rates are usually expressed as an annual percentage of
the amount borrowed. If you borrowed $120,000 at 10% interest,
you'd owe interest of $12,000 for the first year. With most
mortgage plans you'd pay it at the rate of $1,000 a month.
You would also send in something each month to reduce the
principal debt you owe - and the next month you'd owe a bit
less interest.
When your
grandparents bought their home (putting at least half the
purchase price down, by the way), their interest rate was
probably around 4 or 5%. Rates stayed the same for years at
a time. Then in the years following World War II, things became
more turbulent.
As economic
changes speeded up, rates began to change several times a
year. By the l980s, lenders were setting new rates on mortgage
loans as often as once a week - and they still do today. When
inflation hit a high in the '80s, some mortgage loans carried
interest rates as high as 17% - and those who absolutely needed
to buy, paid that much.
Rates
dropped gradually through the 1990s, and by 1998 had reached
their lowest rates in decades. Heading toward the millennium,
home buyers appear to have the most favorable conditions for
mortgage borrowing since their grandparents' days - and without
50% down payments either.
Closing Costs
On the
day you actually buy your new home, in addition to your down
payment and the prepaid property tax and homeowners insurance
premiums, you'll need cash for various fees associated
with the purchase. These expenses are known as closing costs and are paid by both buyers and sellers.
Some closing
costs you pay up-front when you apply for a mortgage loan.
That includes money for a credit check on all applicants and an appraisal
on the property. Keep in mind that even if you don't eventually
receive the loan, that money is not refundable.
Other
closing costs are possible and should be considered when evaluating
your financial situation. These may include, but are not limited
to:
- Title insurance fee;
- Survey charge;
- Loan origination fee;
- Attorney fees or escrow fees;
- Document preparation fee;
- Garbage or trash collection
fees; and the big one
- Points - up-front interest
paid in return for a lower interest rate. Each point is
one percent of the loan amount. Sometimes you can contract
for the seller to pay your points.
TIP:
Consider closing costs when choosing one mortgage plan over
another. The good news is that if your cash is limited,
some mortgage plans allow the seller to pay some or all of
your closing costs, such as title insurance, escrow fees,
and points. Certain closing costs can sometimes be added to
the amount of mortgage loan you're receiving.
Figuring Out Your Monthly Income
When you
apply for a home loan (and even long before that, when you
first speak to a REALTORŪ) the first question may likely be
"How much is your income?" In making this
determination, lenders consider the income of all parties
who will be owners of the property. Be prepared to provide
a monthly accounting of all sources of income.
Calculate the monthly income of you
and all your co-borrowers (if applicable).
Figuring Out Your Monthly Debt
Lenders
are interested mainly in your present monthly payments
because they want to be sure you can handle the mortgage payment
you'll be applying for. Different mortgage plans consider
payments on any debt that won't be paid off within, for example,
six months, nine months, or a year.
Calculate the monthly debt of you
and all your co-borrowers (if applicable).
Amount of Your Down Payment
Your down
payment is paid in cash and is not included as part of
the loan amount. The bigger your initial down payment,
the smaller your loan, which reduces the amount of your payments.
How much
you'll put down depends on the cash you have available and
the amounts you'll need for closing costs and prepaid property
taxes and homeowners' insurance.
Calculate the available funds of you
and all your co-borrowers (if applicable).
Mortgage
plans have various down payment requirements and they can
range from 0% down on a VA (Veterans Administration)
loan to between 3 and 5% down
on a FHA (Federal Housing Administration)
loans to 20% down, the traditional
amount for a conventional loan. In addition, special state
programs for first-time home buyers may set different sums,
which are usually lower than conventional financing.
If you
put less than 20% down on most loans, you'll be asked to protect
the lender by carrying private mortgage insurance (PMI).
Carrying PMI ensures that the debt is repaid if you default
on the loan. This adds approximately an extra half a percent
onto the loan.
FHA mortgages,
in return for their low-down-payment requirements, also charge
for mortgage insurance premiums (MIP).
How Much House Can You Afford?
The amount
of loan for which you qualify is based on two different calculations.
Using what are known as qualification ratios, lenders
evaluate your income and long-term debts to determine a "safe"
amount for your mortgage payments. A fairly standard ratio
is 28/33. Certain mortgage plans sometimes use more liberal
ratios - for example, the FHA currently uses 29/41.
Here's
how it works: With a 28/33 ratio, you'd be allowed to spend
up to 28% of your gross monthly income for mortgage payments.
The lender
will then run a different calculation. This one is your loan
payment and debt payments combined, which may not exceed 33%
of your gross monthly income.
To calculate
exactly how much you may borrow, you also need an estimate
of current interest rates.
For
Example: Suppose you had $1,000 a month for mortgage payment;
at 7% that would let you borrow about $160,000 on a 30-year
loan. At 6% the loan amount would be nearly $175,000. If your
rate were 8%, the loan amount would be a bit less than $150,000.
As part
of this calculation, you also need to estimate and include
the property taxes, homeowner’s insurance, and Homeowner
Association fees (if applicable) you might need to pay, which
are considered part of your monthly expense.
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