Your First Home Purchase Part II

 

by Jonathan G. Cameron, CFP®

In the previous installment of this 2-part series, I discussed how you can prepare yourself for a mortgage application in terms of your credit report and credit score. In this installment I’ll look at the criteria that lenders use when evaluating your application.  

Where Can You Get a Mortgage?

You may obtain a mortgage from a commercial bank, a savings and loan institution, a mortgage company through a loan originator, or even a private individual.

How Much Will They Lend You?

To answer that, let me give you a term and define it. The term is PITI: Principal, Interest, Taxes, and Insurance. PITI is, in other words, the out-of-pocket expense that it takes to keep you living in the home you buy. PITI also includes association maintenance or condo fees.

Mortgage Qualifying Ratios

Lenders use two qualifying ratios in determining how much mortgage you can afford. They will loan you 28% to 36% of your monthly gross income for PITI expenses, and 36% to 41% of your gross income for PITI plus other debt expenses. These qualifying ratios will vary by lender and market, and may be significantly higher depending on the specific financial situation of the borrower. In other words, the higher your credit score, they more your bank may be willing to lend you.  In this post, I’ll assume a lender wants you to demonstrate that you can afford 28% in PITI expenses and 36% of PITI expenses AND debt expenses.

The PITI Math

To make the math easy, say you earn $120,000 gross – not take home, but gross.

That is $10,000 per month. Your bank wants to see that no more than 28% of that, or $2800, would be spent on PITI. That means that the sum of  the mortgage payment itself, insurance on the house, property taxes, and any condo or association fee, would come under 28%. 

Your bank also uses 36% for the second ratio. That means that $3600, to continue our example, would have to cover PITI plus your car payment, student loan payment, Macy's bill, and so on.

Here's An Example

Say you wanted to purchase a home that cost $400,000, putting 20% down, and you can obtain a mortgage at 3.5% for 30 years.  We can calculate the principal and interest, and make some assumptions for the others:  

$1,437 monthly principal and interest

$240 insurance

$150 homeowner’s association

$310 property taxes

Your monthly expenses total $2137. You qualify under the 28% ratio, as your expenses are only 21.37% of your monthly gross.

 Now let’s see how the 2nd ratio, the 36%, comes into play.

Let’s say you have these additional expenses:

$750 student loan

$500 car payment #1

$650 car payment #2

$75 Macy’s

In this scenario, your monthly expenses are $4112, or 41.12% of your monthly income, exceeding the 36% ratio.

Would Exceeding Qualifying ratios Prevent Mortgage Qualification?

Maybe. It depends on the lender and the overall lending environment.  Currently lenders are not sticking strictly to the 28% / 36% standard ratios.  If your credit scores are strong there is usually leeway. See my last post on building your credit score. You always have the option of adding more to the down payment, so that the monthly loan payment would decrease. What else could you do? Pay off the Nordstrom balance. Sell one of the cars and get something with a lower payment. Or shop for a cheaper house.

Is a 20% Down Payment Necessary?

No, but if your loan:value ratio is less than 20% you will be required to purchase private mortgage insurance.  Also, the lower the loan:value ratio, the lower the interest rate, assuming strong credit. 

In the previous example I used 20%, but in actuality you probably don’t need that much. If you are a veteran, you could qualify for a VA loan with little if no money down. First-time home buyers need only put down 3%.

Qualifying people for mortgages is its own specialty. You will be in a much stronger position if you take the time to do the following well before applying for a mortgage:

  • Check your credit report at annualcreditreport.com and verify accuracy
  • Do what is necessary build up your score
  • Save what you can for a down payment
  • Maintain a working budget so you can afford to stay in your home

Being house poor is no fun.  Count on your property taxes rising in the second year of ownership, after the property appraiser sees that the house has changed hands (in Miami-Dade County, property tax increases are capped at 3% per year, so when a house is sold it is revalued for tax purposes.)

In that budget, you’ll want to re-analyzing your federal tax situation to see if you will save any federal tax. Both mortgage interest and $10,000 per year of taxes qualify as itemized deductions.  The standard deduction for a married couple is now $24,400 (2020), so these deductions, plus those for other taxes and charitable contributions would need to exceed $24,400 before any tax savings are realized. 

 For more on this and other financial planning topics, be sure to explore the CameronDowning website.

Get in touch! 

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