4 Lessons That All Future Homeowners Need to Learn
Before you start house hunting it’s essential you take a hard look at how much house you can actually afford. It’s easy to get swept up in the homebuying process and overlook all the financial details that affect what kind of loan you’ll qualify for, how much your monthly payments will be, and all the other “hidden” expenses that come along with your purchase. The best thing you can do is educate yourself before you start shopping and go in with a realistic picture of your budget. Online calculators are helpful, but it’s important to understand what’s behind all those numbers first.
Here are four lessons all future home buyers should know:
LESSON 1: THE 28/36 RULE
28% and 36% are numbers lenders will use when evaluating your loan application, and they refer to your monthly debt. Here’s what they mean and why you should care:
- 28%: The maximum percentage of your gross monthly income (GMI) you should spend on housing expenses.
- 36%: The maximum percentage of debt to gross monthly income (GMI) you should have in total.
Lenders use numbers like this when they are trying to determine your creditworthiness. In the eyes of a lender, if you have around a third of your monthly income earmarked for debt and housing, you’re less likely to default on future payments.
The 28% rule:
It’s important to understand upfront what lenders define as “housing expenses.” These don’t include expenses like utilities, but they do include things like HOA fees (homeowners association), PMI (private mortgage insurance – required when you put down less than 20%), property taxes, and homeowners insurance – all this in addition to your monthly mortgage payment and interest. Including these costs can easily add hundreds of dollars to your monthly expenditures.
Example:
Mortgage, interest, property taxes = $1280
PMI and Homeowners Insurance = $120
HOA = $100
Total monthly housing expenses = $1,500
At $1,500 a month, you would need to gross $5,357 a month in income to be at 28%. ($1,500 / $5,357 = .28 or 28%)
Alternatively, you could take your GMI and multiple it by .28 to get an idea of what you should be spending per month on housing expenses. Example: You gross $3,500 a month: $3,500 x .28 = $980. With this income, your total monthly housing expenses should come in at under $980.
The 36% rule:
The 36% rule is related to the 28% rule, but it includes all your regularly occurring monthly debt like car payments, student loans, or consumer debt. This will sometimes be referred to as your DTI ratio (debt to income). Note that it still does not include expenses like utilities.
Example: In addition to your housing expenses from above, you also pay $200 a month toward student loans, and $150 a month toward your car. Your total debt each month would be $1,500 + $200 + $150 = $1,850. Using these numbers, your lender would want to see at least $5,138 in GMI ($1,850 / $5,138 = .36 or 36%).
The takeaway: Calculating these numbers can be sobering, but they are flexible and only a starting point for you and your lender. Your percentages can swing a few points higher and still be eligible for a loan, but 28/36 is a good benchmark to use as you’re navigating your own path to homeownership. Please keep in mind that these percentages don’t take into account any other monthly payments you have like utilities, groceries, entertainment, health care, etc. It’s up to you to take a hard look at your spending and come up with a realistic and manageable budget.
LESSON 2: FACTOR IN THE DOWN PAYMENT AND CLOSING COSTS
It’s easy to think of switching from renting to buying as simply diverting the money you were paying in rent to your mortgage payment. Afterall, if you can afford $1,300 a month in rent, why can’t you just start paying $1,300 a month toward a mortgage? It’s the down payment (and to a lesser extent the closing costs) that can be a barrier to homeownership for many people.
With a conventional loan, most lenders are looking for you to pay at least 10% of the purchase price up front, but most want closer to 15% to 20%. This is called the down payment. Even for a modestly priced $200K home, that’s $40,000 you may have to come up with right off the bat! Many of us don’t have this kind of money lying around, but the good news is there are programs to help. Down Payment Assistance Programs (DTI’s), or borrower specific loans targeted at groups who may need extra help in purchasing and coming up with the down payment, are two ways to get assistance with these costs. See our blog post here for a comprehensive guide to DTI’s in your state.
Closing costs are fees that the buyer pays at the very end of the home buying process to cover the myriad of expenses and behind-the-screens action that go into buying a home (loan origination fee, title fees, appraisals, and filing fees to name a few). On average homebuyers can expect to pay 2% – 5% of the purchase price in closing fees. Like the down payment, there are assistance programs out there for closing cost help, but you don’t want to be surprised by having to write an $8,000 check when you weren’t expecting it.
LESSON 3: THE TYPE OF LOAN AFFECTS WHAT YOU CAN AFFORD
Many people are surprised to hear there are different types of loans available to potential homebuyers. These federal loans programs are usually designed to help specific groups of people who may not be able to hit the 28/36 rule, have weaker credit, or may not have money for a down payment. If this is you, you may want to look into programs like an FHA or VA loan.
With a conventional loan, most lenders will want you to be close to the 28/36 percentages and be able to put down 10% to 20%. This can be a stretch for many buyers, even those with good credit and steady income. We’ll review the two most popular federal loans and explain how they can affect how much house you can afford.
FHA Loan – FHA loans are government-backed loans funded by the Federal Housing Administration and have much more relaxed requirements than a conventional loan. FHA Loans typically allow up to a 50% DTI which can help you qualify for a house you wouldn’t have been able to with a conventional loan. They also offer lower closing costs. There are some drawbacks though: since FHA loans also offer lower down payments (as low as 3% with a credit score of 580 or higher), this will often increase your monthly mortgage payment, since the more money you put down up front, the less you end up paying each month. You’ll also be required to carry PMI since your down payment is below 20%.
VA Loan – VA loans are government-backed loans funded by the Department of Veterans Affairs. VA loans offer closing cost assistance and some even have 0% down payments, so these are a great option if your DTI is manageable, but you don’t have the money for a down payment. However, like an FHA loan, the decreased or non-existent down payment can mean larger monthly mortgage payments. Additionally, you’ll be required to carry PMI, and the lower your down payment, the higher your PMI payments will be each month. You’ll save money up front, but you may see your monthly payments go up by a couple hundred dollars compared to a conventional loan.
LESSON 4: KNOW YOUR NUMBERS
Your bank or lender will do a thorough evaluation of your current and past financial history when you apply for a loan, and use this information to determine your creditworthiness. You should have a clear idea of your financial portfolio ahead of time, and know where you fall within these parameters before you start shopping.
- Credit Score: Your credit score will help determine if you qualify for a loan, and if so, what kind of interest rate you can get. The higher the score, the lower your rate, and lower interest rates equal cheaper monthly payments. Get serious about maintaining a good credit score (generally considered to be over 700) by making regular payments on all outstanding debt, and limiting or eliminating consumer debt like credit cards.
- DTI: Your debt to income ratio also helps determine what kind of loan you’ll qualify for, ie. how much money a lender will give you. Do your best to get this number under 36% though there are programs out there that accept DTI’s of up to 45%. If you’re in a position to pay off some of your loans, start with the ones with the highest interest rates.
- Income: This is simply your gross monthly income (before taxes). This is a hard number to change if you aren’t in line for a promotion or you’re not moving over to a higher paying job. If you are applying for a loan with a co-borrower or using a co-signer, their income gets added in too. This can help bump your numbers up, but the additional borrowers debt is also added in.
- Savings: Savings is important for two reasons: 1) It shows your potential lender that you are financially responsible and that you have some kind of cushion should making payments become an issue, and 2) You’ll need it for the down payment and closing costs. You don’t necessarily have to have a ton of money in the bank, but lenders will want to see that you’ve got a little skin in the game.
- Monthly Spending: Pull up your bank statements. Bust out a calculator. Make a spreadsheet. It’s time to scrutinize your spending. Are you consistently racking up credit card debt and pushing payments off to the next month or the next paycheck? Look back at several months of your bank statements to get a real, honest look at how much you’re spending each month and if you really can afford a mortgage payment. Factor in all utilities, maintenance, and repairs that come with owning a house –you’re your own landlord now and there’s no one else to cover these costs.
- Mortgage Rates: Mortgage rates are set by the Federal Reserve and can and will fluctuate. They are at near historic lows right now so if you’re able to buy, now is a good time as a low interest rate will give you a low monthly payment and you’ll save money on interest over the life of the loan. That said, to get the lowest rate they offer, you have to prove you’re a reliable borrower and you do that by having a good credit score, and by hitting the 28/36 percentages. Some loan programs are able to secure lower interest rates for borrowers that wouldn’t normally qualify.
Bottom Line: It all comes down to you to know how much you can really afford each month. Remember, just because a lender approves you for a loan for $300K doesn’t mean you have to (or should) spend that much. Lenders will offer you the most they can while still feeling sure you’ll be able to pay it back. The number they’re comfortable with may not be the number you’re comfortable with. The lender doesn’t know about your life or your veterinary bills, or how you’re trying to save up for a vacation, or the money you’re putting away for your daughter’s college fund. Be realistic, be honest, and once you’ve done the math – stick to your game plan!