Financing Your New Home
LOOKING TO BUY A NEW HOME,
but not sure how much you can afford? It is imperative that you “get your ducks in a row” before making a decision. Most first time home buyers assume they just need a preapproval letter from a bank. But this can lead to financial stress and even foreclosure. It is up to you to calculate how much you can afford. Letting the bank tell you how much you can spend is not prudent. You need to know your Debt-to-Income ratios as well as your Credit Score in order to effectively determine how much you can afford to spend on a home.
FIRST THING’S FIRST
The first step is to calculate your Debt-to-Income Ratio. There are two components to this ratio. The first is called your “top line” ratio. This is a measure of how much you spend per month on home expenses such as Principal, Interest, Taxes, and Insurance. This ratio should not exceed 28% of gross monthly income. The second is known as your “bottom line” ratio. This is a way to determine how much of your monthly income is spent on servicing all of your debt. Most Financial Planners will recommend that you keep this ratio under 36% but some banks will let you go as high as 43%.
DO THE MATH
Let’s look at two examples in order to understand why we look at these ratios and what these ratios mean to banks. First, take an example where a family earns $96,000 before taxes. They are looking to buy a $500,000 home and will put down 20% ($100,000). Can they afford this house? Let’s look at the numbers: $96,000/12=$8,000 gross income per month. $8,000 x .28= $2,260 (the maximum they can afford to spend on housing). Unfortunately, after accounting for Principal, Interest, Taxes, and Insurance, their monthly payment would be $2,519 per month (assuming 3.5% APR for 30 years with taxes and insurance costing $550/month). Therefore, they can’t afford to buy a $500,000 house. Now, let’s look at a family earning $70,000 per year. They are looking to buy a home but don’t know how much they can afford. Working the top-line ratio, we can calculate their maximum monthly payment. $70,000/12 = $5,833.33 (gross income per month). Multiply $5,833.33 x .28 and you get $1,633.33 which is the most they can afford to spend per month on housing. Next, we can use the Mortgage Calculator on bankrate.com to determine that a $300,000 home with 20% down will cost $1,630/month (assuming 3.5% APR for 30 years with taxes and insurance costing $550/month). Therefore, this house is affordable.
CREDIT SCORE
The next step is to determine your Credit Score. Be prepared to spend several months improving your credit score. The additional time you take building your credit score can serve two purposes. First, the lowest interest rates are offered to buyers with excellent credit. Lower interest rates result in less money being spent on interest. For example, borrowing $300,000 over 30 years and saving just 0.5% on the interest rate can save you more than $30,000 in interest over the life of the loan! Second, you can use this time to save additional funds to add to your down payment. Applying an extra $4,000 towards your down payment may save you an additional $2,500 in interest over the life of a 30-year mortgage.
WHAT IS PMI?
Putting down less than 20% on your home may cause you to pay additional fees. These fees are known as principal mortgage insurance (PMI) or the mortgage insurance premium (MIP) for FHA loans. PMI fees are typically around $150 - $200 per month as they can range from .50% - 2.25% of the home value. PMI typically can be cancelled once the loan to value (LTV) ratio exceeds 80%. MIP tends to be less expensive on a monthly basis but you may be stuck paying it over the life of the loan. Many people will say this is just the cost of owning a home but that is not the truth. The reality is that this is the cost of buying a home without preparing. An extra payment of $200/month may not sound like much but that adds up to $2,400/year. Over 30 years, that will cost you $72,000! As of 2019, there were approximately 128 million households in the United States. According to Zillow.com, 43% of home buyers put down 20% or more on their home. That means 57% of home buyers put down less than 20% and may be subject to PMI or MIP. Some people will tell you that PMI is worth it, but I beg to differ. If you take the $2,400 you would have spent per year on PMI and invested it, you would have $226,706 in 30 years (assuming a 7% rate of return).
RISING COST OF HOMES
Speaking of appreciation of the property, one of the reasons people buy a home is to participate in the upside potential of owning a home. This is an advantage over paying rent. The information presented here is not meant to suggest that you don’t buy a home. Rather, it points buying a home at the right time. This will enable you to save money on interest and PMI paid, as well as allow you to participate in the appreciation of the property. According to data from the U.S Census Bureau, the median cost of a home in 1970 (adjusted for inflation) was $107,291. By 2017, this number had increased to $217,600. That is a 103% increase! Keep in mind that these numbers were vastly different by state. For example, Ohio homes only increased about 50% in this time period while homes in Washington, D.C increased by 352%.
MAINTENANCE COSTS
Factor in the costs of maintaining a property. Setting aside a small amount of money each month will help pay for the cost of repairs. According to this article on fool.com, you may want to save between 1%-4% each year for such costs. For a $200,000 home, this would mean saving between $2,000 - $8,000 per year for maintenance and repairs.
CLOSING COSTS
Remember to also factor in closing costs when buying a home. A recent article from Zillow showed that closing costs can range from about 2% - 5%. For a $200,000 home, this would equate to closing costs of $4,000 - $10,000. Keep in mind that you may be able to negotiate and have the seller pay some, or all, of the closing costs. This is more likely during a “buyer’s market” but you can always discuss this option with your Real Estate Agent.
WRAP IT UP
This article discussed several steps to take before buying a home. Don’t forget to review your income and expenses before heading to the bank to apply for a mortgage. You will also want to keep in mind that banks are in business to make a profit. It is your job to pay the least amount possible for your home. Any money you save can be used to build your Emergency Fund, save for repairs, Invest, and/or enjoy. You should also do your homework and find a local real estate agent who is familiar with the neighborhood where you want to buy your home. A good agent can help you find comparable (comps) properties you can use to determine your offer.
