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Archive for the ‘Affordability’ Category

The question that I am asked most by potential homebuyers is “How much can we afford?”   This is a loaded question.  The first thing I tell my clients is I cannot tell you how much you can “afford”, but I can tell you how much you will qualify to borrow.  There is a distinct difference between the two and this is something that unfortunately, many homebuyers do not understand.   More on this later.

Lets examine how lenders determine how much you can borrow.  Every bank approaches this the same way and the math is extremely easy.  Lenders look at two major ratios to determine how much you can borrow:

Front Ratio 

frontratio.jpgThe front ratio is the total housing payment divided by your gross monthly income.  Essentially, the front ratio tells the lender what percentage of your gross income is spent on housing.  The industry standard for the front ratio is 28%. In other words, under traditional lending guidelines, borrowers typically spend 28% of their gross income on their housing payment.

Example: If your total household income is $10,000 per month, you should be able to spend approximately $2800 on your total housing payment. $10,000 x 28% = $2800.   The total housing payment consists of principal, interest, taxes, and insurance/condo fees (PITI).

Back Ratio: 

backratio.jpgThe more important ratio is the back ratio.  The back ratio is calculated the same way as the front ratio, but this time we include your monthly debts.  The back ratio is the total housing payment PLUS any installment and revolving debt divided by your gross monthly income.  The only debts that lenders consider are installment and revolving debt.  Installment debts have the same monthly payment each month.  These are usually car or student loans.  Revolving debts are credit cards.  We use the minimum monthly payment required by your credit card company as reported on the credit report. Lenders do not consider miscellaneous debts such as cell phones or cable bills.

General underwriting guidelines stipulate that your back ratio should be 36%.  In other words, you should be able to comfortably spend 36% of your gross monthly income on housing and major debts.  In our example above, that would equate to a total of $3600.  So if we spend $2800 on our total housing payment, that leaves $800 to spend on car payments and student loans.

So what does this mean in terms of a purchase price?  A good rule of thumb to follow is you can spend 3-4x your gross annual income on a home depending on your debt load.    So if you make $100k per year, you can spend $300 – $400k pretty easily.

It is important to remember that the ratios are a guideline and they are flexible.  Most lenders will allow back ratios up to 45% without blinking an eye.  Some will even go to 50%.   I have gotten loans approved up to 65% with automated underwriting programs.   However, this does not mean you can necessarily afford to spend half of your gross income (remember, you still have to pay Uncle Sam) on a house.   This is why I said there is big difference between what a lender can qualify you for and what you can afford.  If you enjoy eating out at Spago’s, maxing out your 401k, traveling, or spending money on anything other than your house, you do not want a back ratio approaching 50% because you will be flat BROKE.  Your loan officer/mortgage broker should discuss with you debt ratios to ensure you are ready to handle the debt of homeownership.  If your loan officer has not taken the time to provide an analysis of your debt ratios, find another loan officer.

I would encourage anyone thinking of buying a home to sit down and complete a DETAILED budget prior to getting fixated on how much they want to spend on a house.  This budget should track every expenditure from your student loans to how much you spend on Starbucks coffee.  Next you need to figure out how much money you need to save each month.    After you do all of this, put away the amount you feel you can spend on a home each month into a savings account for three months.   If you can’t do this without feeling an ounce of pain, then you need to readjust your purchase price because you will be spending too much on your home.

I have some great spreadsheets that will help you budget and calculate your ratios.   As always, if you have any questions, don’t hesitate to give me a call.

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approved-opt.jpgThe first step anyone considering buying a home should take is to get themselves pre-approved.  A pre-approval means you are serious about buying a home and demonstrates that you have the financial means to afford one.  Unfortunately, most buyers do not get  pre-approved which leads to quite a bit of headaches for everyone involved in the home buying process.

Buying a home can be fun and exciting.  However, people often get caught up in the HGTV glamour of looking at stainless steel appliances and hardwood floors that they forget that they are undertaking one of the largest investments of their lives.   I can admit, looking at houses is fun, but talking about finance is boring unless you are a self-admitted geek like me so I understand the consumer mentality.  However, you need to understand that talking about your financing BEFORE you go house hunting is what will save you money and ultimately make the process much smoother and pleasant for you. 

Most of the horror stories you hear about buying a home are ususally centered around the fact that the borrowers did not get themselves pre-approved prior to making an offer on a property.  Not a month goes by where I don’t get a call from a frantic buyer who is in a bind because they are having trouble getting financing and now they are in danger of losing the property or their earnest money.  I am not talking about small issues either.  Every deal has a few bumps in the road.  I am talking about issues that leave me thinking to myself “Who in the hell told you that you were qualified to buy a home?  You couldn’t get a loan to get a stick of gum.”  By simply taking the time to really get themselves approved for a mortgage this could have been prevented.

A pre-approval means the lender has completed all of the due diligence necessary to make a formal underwriting decision.   In order to get pre-approved, you must submit:

  • A signed and completed loan application along with required federal and state disclosures
  • Thirty days paystubs and/or two years tax returns if you are self-employed, commissioned or receive substantial bonus income
  • Two years w-2’s
  • Statements verifying availability of assets to meet the downpayment and reserve requirements.  Usually three months.
  • Lender obtains a tri-merge credit report with FICO scores from Experian, Transunion, and Exquifax

If you have not submitted the above documentation to your lender, you have NOT been pre-approved.  PERIOD.  Regardless of what you hear on the television or see on the internet, mortgage lenders do not approve loans for hundreds of thousands of dollars in five minutes.  It simply does not work that way.   Real pre-approvals take a week or so to complete because the documentation must be reviewed by the lenders’ underwriters.

Pre-approvals are important not only because they help eliminate unwanted surprises and stress, but they make you a more serious buyer.   Most good Realtors will not spend time with borrowers who have not been pre-approved.  They don’t want to waste their time playing taxi for borrowers who can’t get financing.  Second, when you can submit an offer to a seller with a strong pre-approval letter, it makes it more likely the seller will accept your offer.  Seller’s don’t want to pull their property off the market only to have you not be able to buy it. 

Most borrowers get themselves pre-qualified, not pre-approved.  A pre-qualification means you might have talked to a loan officer about your situation.  In fact, the loan officer may have even pulled your credit.  However, unless the loan has gone across an underwriter’s desk with the above documentation, the loan officer’s opinion doesn’t mean much.  That is the difference between a pre-approval and a pre-qualification.  A pre-approval is FACT while a pre-qualification is an opinion.  

Professionals in this business do not tell you to go through the pre-approval process because we like to waste your time.  We do it because we don’t like to waste ours.

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TaxesAfter much lobbying, private mortgage insurance (PMI) is now tax deductible for refinance and purchase loans taken out after January 1, 2007.  This benefit was buried deep in the Tax Relief and Healthcare Act of 2006.  This is great news for millions of homeowners making owning a home more affordable.   For decades, lenders have required homeowners who do not have a 20% down payment or at least 20% equity in their homes to pay PMI.  PMI is an insurance policy the lender takes out on you to insure that if you were to default on the mortgage, the lender would recoup their money.  Put another way, it is an insurance policy you pay for but provides no benefit to you.  It doesn’t help you if you default, it helps the lender.   There used to be absolutely no financial reason to ever elect to pay PMI and it was to be avoided at all cost if possible.  PMI can be several hundred dollars per month depending on your credit profile.

While this is great news, do not mistake this bill passing as something being done as an act of kindness.  PMI companies have seen their policy revenue fall dramatically over the past several years with the development of piggyback mortgages.  A piggyback mortgage is where the loan officer breaks your mortgage up into two pieces.  They give you a first mortgage of 80% of the purchase price and a smaller second mortgage for the remaining balance.  For instance, if you only had five percent as a down payment you would get an 80% first mortgage and a second mortgage for 15% and you would put five percent down.  By structuring the loan this way, you do not have to pay the PMI charges.  The combined payment with the two mortgages is lower than one mortgage with PMI.   Piggyback mortgages have saved homeowners thousands of dollars.  In fact, I probably only close a handful of transactions annually with PMI because there are plenty of ways to avoid it for most borrowers.  Typically, if PMI is required it is because there are no other options.

This bill is the result of lobbying by PMI companies so they wouldn’t find themselves out of business.  Nevertheless, it is still a good thing.  However, even with PMI being tax deductible it still probably won’t be better than avoiding it altogether.

The main points of the bill are:

  • Homeowners making less than $100,000 per year may deduct the full cost of the annual mortgage insurance premiums
  • If adjusted gross income is above $100,000, the deductible portion of the premium is reduced by 10% for each $1000 or fraction thereof.  Now in english: this means if you make $101,000, you can deduct 90% of the mortgage insurance premiums paid.  This also means the maximum income allowed for the deduction is $110,000.
  • Mortgage loan (purchase or refinance) must have been closed in 2007.  This means you won’t be able to deduct the premiums on your taxes this April.  You have to wait until next year.   PMI premiums paid in 2006 are not deductible.
  • Only primary and second homes are eligible.  Rental income disqualifies the second home deduction.

If you obtain a mortgage this year with PMI, make sure you talk with your tax professional about this new benefit to fully take advantage of it.  Mortgage insurance company, MGIC, has a good presentation on the bill.

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I know this article probably won’t win me many friends with people in the industry, but I just thought I would point out that home ownership is expensive.  Don’t get me wrong, I think owning your own crib is a joy like no other.  Everyday when I get home I am thankful that I have a successful career that allows me to afford such a beautiful place in a great area.   However, the goose bumps I get when I look at my little castle are expensive.

One of the biggest mistakes I see home buyers make is underestimating how much it costs to keep up a home.  Many people focus on the cost of the mortgage payment, property taxes, and insurance.  In fact, those are the only items lenders consider when qualifying you for a mortgage.  However, the actual cost is a lot more.

For most people, their home is their largest investment.   However, in order for this investment to have the greatest return, you have to manage it – spend money.   The upkeep costs should not be underestimated.    For example, keeping your lawn nice and tidy is a priority for many homeowners.  Unfortunately, for the broke homeowners, manicured lawns cost money.  You need to buy the lawnmower, not to mention the edger.  Oh yeah, I forgot about the weed wacker.  Garden hoses.  Gutter protection.  Fertilizer.  The list goes on and on.  Not the type to do yard work?  Lawn services run about $100 per month.

The point is simply that when deciding how much to spend on a house keep in mind what it costs to keep it in tip top shape. You want to make sure that your budget can handle another $100-$200 per month in general home maintenance.  If you don’t spend a little money on managing your house, your home will quickly begin to look like the neighborhood crack house and you won’t see as big of return on your investment.

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