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How much home can I afford?

The home you can afford is a product of how much money you have available for a down payment and how large a mortgage you can qualify for. Another way of looking at the latter is, how much of a monthly payment can you support on your present income?

Lenders rules of thumb for mortgage affordability

Most lenders use two simple formulas to quantify your ability to pay on a conventional mortgage.

• 28% Rule: No more than 28% of your gross monthly income (including all verifiable income sources including spouse, if applicable) can be spent on your housing costs including principle, interest, taxes, and insurance (PITI). EXAMPLE - If your gross monthly income is $4,000, your maximum monthly payment would be $1120.00.
• 36% Rule: These lenders consider your total indebtedness and allow 36% of your monthly income to pay for your mortgage after all other long- term debts and obligations are satisfied. To calculate this figure, subtract monthly payments for other loans such as auto, furniture or appliances, child support, etc. from your gross income. Then multiply the resulting figure by 36% (.36). The outcome will give you a monthly payment you can afford. EXAMPLE: A monthly gross income of $4,000 would support a maximum mortgage payment of $1,440 per month if you had no other long term debts. An existing auto loan with a $250 monthly payment would reduce your monthly base to $3,750 and your maximum affordable mortgage payment to $1,350. A given lender may seek to qualify you under either one or both of these criteria. The affordable monthly payment will determine how much you can borrow based on current interest rates

Once your mortgage eligibility is established, the other factor related to home affordability is the amount of cash you have on hand. Add the down payment you expect to make to the mortgage amount you can afford and that will give you the pricing of homes you should be looking at.

Remember that closing costs, moving expenses, repairs and remodeling will also impact how large a down payment you can make. Other variables such as interest rates, the type of loan, and access to FHA or VA financing can affect how much home you can afford. Your real estate agent can help you assess all these factors and determine the price range of homes that will fit your circumstances.

Choosing a Mortgage

The next question is: What type of mortgage is right for you. The answer will depend on your goals, desired terms, credit worthiness, and other individual circumstances. There are four basic mortgage plans that cover the lions share of all home mortgages created.

Fixed-Rate Conventional Mortgage

By far, the most common alternative, conventional loans are made directly on the strength of the buyers own credit without any 3rd party participant or guarantor. Conventional loans are typically for 15, 20, or 30 years. The interest rate remains constant throughout the term of the loan. By paying off the loan faster, home equity grows faster and the buyer can reduce interest expense by many thousands of dollars. Naturally, monthly payments will be somewhat higher on a shorter payoff period. Conventional loans have the advantages of quick processing and long-term stability.

Adjustable-Rate Mortgage (aka ARM or Variable Rate)

Instead of a fixed rate loan as in the conventional, an ARM may fluctuate upwards or down over the life of the loan based on the performance of a particular market index such as one-year Treasury bills, for example. As a result, monthly payments will also be adjusted periodically. Most such loans have a cap on the interest rate to protect the buyer from extreme fluctuations in the market. The primary advantage of such a loan is that the interest rate is typically lower than a fixed rate mortgage in the early years of the loan. This allows the buyer qualify for a larger loan amount, and handle increasing payments as earnings and buying power rise.

FHA Loan

FHA is an agency of the US government that insures home loans, typically for first-time or lower income buyers. This gives qualifying individuals greater access to home ownership by increasing lenders willingness to make potentially higher-risk, low down payment loans. Down payments can be as low as 2.5% and second mortgages may be permitted. FHA will also finance all closing costs on a single family home purchase.

Costs for FHA insured financing include a mortgage insurance premium (MIP) paid in advance as well as a monthly fee. Some or all of the advance fee may be included in the face amount of your loan to avoid increasing costs at closing. FHA imposes maximum loan amounts that vary from place to place around the country.

In addition to the low down payment, FHA loans offer the qualified buyer low interest rates, long terms, assumability and no prepayment penalties.

VA Loan

Similar to FHA insured loans, the VA will guarantee loans for military veterans only. VA loans are subject to limitations on the loan amount but no down payment is required. VA guaranteed loans can also be combined with second mortgages and are assumable by qualified buyers. Interest rates and points are negotiable depending on the lender.

The no money down feature is the most attractive advantage of this loan. Other advantages are that the points are paid by the seller, there is no prepayment penalty, and the assumability of the loan is particularly attractive to buyers should you decide to sell before the loan is paid off.

Finding a Mortgage Lender

Not all loans or lenders are created equal. It pays to shop around for the best interest rate and the best terms for your situation. Your agent can help you determine which of the options above is preferable for you and refer you to several lenders or mortgage brokers who can help.

Its easy to find yourself on the defensive when seeking to qualify for financing. Remember you represent business for the lender and will be paying them tens of thousands of dollars in interest over the life of the loan. Make sure you feel comfortable in doing business with them. The following Lender Interview Checklist suggests several questions to ask when interviewing a potential lender.

Lender Interview Checklist

1. What kinds of loans do you offer (fixed and adjustable rate)?
2. How much of a down payment (if any) is required?
3. What is the length of time to repay the loan (15 years, 30 years other)?
4. Is there a penalty for paying off the loan early?
5. Are there additional fees and if so what are they? Possible fees include credit report, survey, points, appraisal, title insurance.
6. What are the terms on an adjustable-rate loan?
   • How often can the rate be adjusted?
   • Whats the maximum rate change at each adjustment?
   • How often can the monthly payment be changed?
   • Is there an interest rate cap and if so, what is it?
   • Can the length of the loan be extended?
   • Can the loan be converted to a fixed rate and if so, under what conditions?
7. Can a second mortgage be provided if needed and what are the terms?
8. How much insurance do I need and what kinds
9. What inspections are required?