There's no point wasting time and energy house-hunting
before you know what you can afford. So your
nexts step is to assess your finances:
Does it Pay to Buy a Home or Simply
to Rent?
If,
like most first-time buyers, you are presently renting,
it's easy to calculate your cost - simply, the monthly
rent you pay. (Utilities, phone, cable, and other costs
can be ignored in this comparison because they'll be
approximately the same whether you rent or buy.)
Use our Rent
vs. Buy Calculator to help you evaluate whether
homeownership is a sound financial option right now.
But calculating the cost of homeownership is much more
complicated, because income
tax considerations affect your bottom line.
And there is, in addition, the uncertainty about how
much the value of your home will rise (or even fall)
in the coming years.
As
a tenant, you may be taking a standard deduction on
your income tax return. This is the time to judge how
that standard deduction stacks up against the amount
you'd be able to subtract from income if, like most
homeowners, you itemized deductions instead.
Once
you itemize, you can deduct:
- Home mortgage interest;
- All real estate taxes on any
property you own;
- Your state income taxes;
- Charitable contributions;
- Medical and dental expenses
that exceed 7.5% of your income;
- Personal property taxes if
your state has them; and most important
- Certain moving
expenses
At
the start of a mortgage repayment schedule, when
the debt hasn't been reduced yet, almost all of your
monthly payment goes toward interest. A bit goes toward
reducing principal (the amount borrowed), so that the
next month you're borrowing a bit less, and owe a little
less interest. That allows more of your next payment
to go toward reducing principal. However, this process
is very slow in the beginning and the interest portion
remains high for many years.
Between
the mortgage interest and the property tax deductions,
you can figure that Uncle Sam is shouldering part of
your monthly mortgage payment - 28% of it, in fact,
if that's your tax bracket. Your state income tax bracket
can also be added to that, before you calculate how
much you save on income tax as a homeowner.
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Interest
Rates and How They Change
As
you start shopping for a home loan, your first question
of each lender will probably be "What's your interest
rate? How much are you charging?"
Interest
rates are usually expressed as an annual percentage
of the amount borrowed. If you borrowed $120,000
at 10% interest, you'd owe interest of $12,000 for the
first year. With most mortgage plans you'd pay it at
the rate of $1,000 a month. You would also send in something
each month to reduce the principal debt you owe - and
the next month you'd owe a bit less interest.
When
your grandparents bought their home (putting at least
half the purchase price down, by the way), their interest
rate was probably around 4 or 5%. Rates stayed the same
for years at a time. Then in the years following World
War II, things became more turbulent.
As
economic changes speeded up, rates began to change several
times a year. By the l980s, lenders were setting new
rates on mortgage loans as often as once a week - and
they still do today. When inflation hit a high in the
'80s, some mortgage loans carried interest rates as
high as 17% - and those who absolutely needed to buy,
paid that much.
Rates
dropped gradually through the 1990s, and by 1998 had
reached their lowest rates in decades. Heading toward
the millennium, home buyers appear to have the most
favorable conditions for mortgage borrowing since their
grandparents' days - and without 50% down payments either.
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Closing
Costs
On the day you actually buy your new home, in addition
to your down payment and the prepaid property tax
and homeowners insurance premiums, you'll
need cash for various fees associated with the purchase.
These expenses are known as closing
costs and are
paid by both buyers and sellers.
Some closing costs you pay up-front when you apply
for a mortgage loan. That includes money for a credit
check on all applicants and an appraisal
on the property. Keep in mind that even if you don't
eventually receive the loan, that money is not refundable.
Other
closing costs are possible and should be considered
when evaluating your financial situation. These may
include, but are not limited to:
- Title insurance fee;
- Survey charge;
- Loan origination fee;
- Attorney fees or escrow fees;
- Document preparation fee;
- Garbage or trash collection
fees; and the big one
- Points - up-front interest
paid in return for a lower interest rate. Each point
is one percent of the loan amount. Sometimes you can
contract for the seller to pay your points.
TIP:
Consider closing costs when choosing one mortgage plan
over another. The good news is that if your cash
is limited, some mortgage plans allow the seller to
pay some or all of your closing costs, such as title
insurance, escrow fees, and points. Certain closing
costs can sometimes be added to the amount of mortgage
loan you're receiving.
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Figuring
Out Your Monthly Income
When
you apply for a home loan (and even long before that,
when you first speak to a REALTORŪ) the first question
may likely be "How much is your income?"
In making this determination, lenders consider the income
of all parties who will be owners of the property.
Be prepared to provide a monthly accounting of all sources
of income.
Calculate
the monthly income of you and all your co-borrowers
(if applicable).
Figuring
Out Your Monthly Debt
Lenders
are interested mainly in your present monthly payments
because they want to be sure you can handle the mortgage
payment you'll be applying for. Different mortgage plans
consider payments on any debt that won't be paid off
within, for example, six months, nine months, or a year.
Calculate
the monthly debt of you and all your co-borrowers (if
applicable).
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Amount
of Your Down Payment
Your
down payment is paid in cash and is not included
as part of the loan amount. The bigger your initial
down payment, the smaller your loan, which reduces the
amount of your payments.
How
much you'll put down depends on the cash you have available
and the amounts you'll need for closing costs and prepaid
property taxes and homeowners' insurance.
Calculate
the available funds of you and all your co-borrowers
(if applicable).
Mortgage plans have various down payment requirements
and they can range from 0% down on a VA
(Veterans Administration) loan to between
3 and 5% down on a FHA
(Federal Housing Administration) loans to
20% down, the traditional amount for a conventional
loan. In addition, special state programs for first-time
home buyers may set different sums, which are usually
lower than conventional financing.
If
you put less than 20% down on most loans, you'll be
asked to protect the lender by carrying private mortgage
insurance (PMI). Carrying PMI ensures that the debt
is repaid if you default on the loan. This adds approximately
an extra half a percent onto the loan.
FHA mortgages, in return for their low-down-payment
requirements, also charge for mortgage insurance
premiums (MIP).
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How Much
House Can You Afford?
The
amount of loan for which you qualify is based on two
different calculations. Using what are known as qualification
ratios, lenders evaluate your income and long-term
debts to determine a "safe" amount for your
mortgage payments. A fairly standard ratio is 28/33.
Certain mortgage plans sometimes use more liberal ratios
- for example, the FHA currently uses 29/41.
Here's
how it works: With a 28/33 ratio, you'd be allowed to
spend up to 28% of your gross monthly income for mortgage
payments.
The
lender will then run a different calculation. This one
is your loan payment and debt payments combined, which
may not exceed 33% of your gross monthly income.
To
calculate exactly how much you may borrow, you also
need an estimate of current interest rates.
For
Example: Suppose you had $1,000 a month for mortgage
payment; at 7% that would let you borrow about $160,000
on a 30-year loan. At 6% the loan amount would be nearly
$175,000. If your rate were 8%, the loan amount would
be a bit less than $150,000.
As part of this calculation, you also need to estimate
and include the property taxes, homeowner’s insurance,
and Homeowner Association fees (if applicable) you might
need to pay, which are considered part of your monthly
expense.
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