How Much House Can You Afford?

filed under: Mortgages
To determine how much of a home you can afford, you need to calculate your expected monthly payment. Most of your payment will go toward loan principal and interest, also called P+I. However, your monthly payment is also likely to include amounts for property taxes and homeowner's insurance. Because of these extra payments, your monthly P+I payment is sometimes called your P+I+T+I payment. If you plan to make a down payment of less than 20% of the home purchase price, you will also have to add an additional amount for private mortgage insurance ( PMI). Lenders require PMI to insure against the higher risk of default that occurs with loan-to-value (LTV) ratios greater than 80%. ( An LTV of 80% is equal to a down payment of 20%.)
Your housing ratio is your total monthly payment divided by your monthly gross income. Generally, the ratio should not be more than 28%. For example, if your monthly P+I+T+I payment is $1,400, your monthly gross income should be at least $5,000.
Your debt ratio is the sum of your P+I+T+I and any other credit card or loan payments, divided by monthly gross income. Debt ratio will obviously be a higher percentage, since most people have other loans or credit card debt. Generally, your debt ratio should not be more than 36%. In this example, with monthly gross income of $5,000, your total loan payments (including the proposed mortgage loan payment) should not be more than $1,800.
Mortgage lenders regularly use these 28% and 36% ratios as guidelines. The ratios change over the course of the economic cycle. When the economy is strong, lenders tend to raise the ratios, making it easier obtain a loan. When the economy is weak, lenders tend to lower the ratios, making it harder to obtain a loan. A weaker economy leads to lower interest rates, which makes it somewhat easier to qualify.
You may wish to limit a home search to home prices that allow you to obtain a mortgage loan amount that is conforming. A conforming loan amount is within the annual limits set by Fannie Mae and Freddie Mac, two government-sponsored enterprises that focus on investing in residential mortgages.
For 2008, the conforming loan amount for Fannie Mae- and Freddie Mac-sponsored loans is $417,000. For Alaska and Hawaii, the limit is $625,500. A conforming loan allows you to avoid private mortgage insurance if you make a down payment of at least 20% on the home purchase price.
If your mortgage loan is conforming, you will likely have an easier time finding a lender than if the loan is non-conforming. (A non-conforming loan is called a "jumbo" loan.) Generally, interest rates on conforming loans are lower than on non-conforming loans.
How much of a home you can afford also depends on the amount of down payment you have saved. If you don't have one saved, consider these alternatives:
Federal government mortgage-financing programs. The U.S. Dept. of Housing and Urban Development (HUD) and Dept. of Veterans Affairs (HUDVA) run loan programs for first-time homeowners and veterans of the armed forces. These programs require little or no down payment.
Obtain private mortgage insurance. Private mortgage insurance, discussed above, allows you to make a down payment of as little as 5% of the home purchase price.
Borrow against the value of your investments. Some financial institutions offer mortgages that are backed by the value of your investments. With these programs, your investment portfolio serves as the collateral for your mortgage.
Borrow from your employer-sponsored retirement plan. Most employers allow you to borrow against the value of your 401(k) plan. (The IRS does not allow you to borrow from an IRA, however.) Remember that if you leave your job, you'll likely have to pay back the full amount of the loan immediately.
Withdraw funds from an individual retirement account. While the IRS does not allow you to borrow from an IRA, it does allow penalty-free withdrawals of up to $10,000 for first-time homebuyers. However, you will owe income taxes on the amount of the withdrawal.
State government housing programs. Most states have programs to help residents buy their first homes. In addition to a down payment, you should expect to pay closing costs on your home loan.
How much you pay in closing costs depends in part on how many points you pay on your loan. One point is equal to 1% of the loan amount. Generally, closing costs range from 3 to 6 percent of the home purchase price. In addition to loan points, other major categories of closing costs include: Fees to process your loan application, review your loan documents and fund the loan.
Payments to fund an impound account. These funds are used to pay your homeowner's insurance and property taxes. Generally, you replenish an impound account as you make your mortgage payments.
Fees for legal and appraisal services, credit review, and title search and insurance. You will also have moving expenses if you buy a home in a different city. If you move to another region of the country, you may also face a change in the cost of living. If you're moving to a new city to take a job, your new employer may reimburse you for these expenses. If not, you can deduct them from your taxes. You'll need to complete IRS Form 3903: "Moving Expenses." To compare the cost of living between cities, you may wish to visit the ACCRA website, a non-profit organization that provides cost-of-living indexes for more than 350 U.S. cities.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a mortgage lender or financial adviser.
2008-07-21 17:01:01
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