Financial Evaluation and Loan Qualification
The single biggest part of purchasing a home involves qualifying for and securing a mortgage. This section will address a variety of questions related to the financial aspects of your home purchase. It also places you in a stronger negotiating position if you are approved by a lender before you enter the marketplace.
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 (see table below.)
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.
The following table will give you an idea of how large a mortgage you are likely to qualify for at varying interest rates based on your affordable monthly payment.
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Note: Above figures are for 30 year fixed rate mortgage and assume a 10% down payment. Payment amount is principal and interest only and does not include taxes, insurance or other fees related to home ownership
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 lion’s 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 buyer’s 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.
It’s 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?
- What’s 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?
Be Prepared!
You won’t be the only one asking questions in this exchange. The lender will want a good deal of information from you. Here’s the information you should be prepared to give:
1. What kind of mortgage do you prefer? (fixed, variable, etc.)
2. How much money do you wish to borrow?
3. What length of time for payoff do you prefer (15 yr., 30 yr., etc.)
4. How much do you plan to put down?
5. What is the verifiable source of your down payment?
6. What is your current income and who is your employer(s)(provide company name, address and contact)? Previous employment history may also be required.
7. What are your current assets? (monthly income, checking/savings account balances, valuable possessions [car, boat, jewelry, other real property, investments, etc.
8. What liabilities have you? (car loan, credit cards, other debt - include account numbers)
9. What is your social security number?
10. A copy of your sales contract (offer)
So how much money should I put down on a house?
There are advantages and disadvantages to both large and small down payments. The decision is a matter of personal choice and financial circumstances.
A large down payment produces instant equity, potentially a smaller mortgage amount and or lower monthly payments and more leverage in negotiating for a lower interest rate or larger loan. Less money down, on the other hand, could mean more money for other costs such as improvements or immediate living expenses. Although payments will be higher on a larger mortgage, you will have the advantage of a greater tax deduction for mortgage interest cutting your tax bite.
A down payment of less than 20% (in other words financing 80% or more of the total home value) will result in the requirement that you pay for a mortgage insurance policy (MIP or PMI). This will also add to your monthly housing expense.
How do I come up with cash for a down payment?
Here are some options to consider if you don’t have sufficient money in personal savings:
Tax free gift - Often parents or others will be happy to make a gift of up to several thousand dollars to help a young individual or couple get started in a home of their own. Make sure the gift is accompanied by a “gift letter” stating that there is no obligation to repay.
Borrow against equity in a life insurance policy. If you have equity in a company pension plan, you may often borrow against it with very favorable interest rates.
Withdraw cash from a retirement savings plan such as an IRA. (This is not used often because of the penalties for early withdrawal.)
Request a one-time cash bonus in lieu of a raise in pay from your employer
Use your own business or other personal asset as collateral on a cash loan.
Equity Sharing - Ask a friend, relative, business partner or other investor to provide cash for the down payment in return for a share in the equity in your home. (You can always buy them out later as your financial circumstances improve.)
Be creative! You’ll be surprised at how many people are willing to help. “Ask and you shall receive!”
Which comes first, the home or the loan?
Go for the money! There may be exceptions, but generally speaking, if you’re serious about making a purchase, this works best. Entering the marketplace with your financing in line -- at least to the extent of having a lender who will qualify you up to a specific amount -- puts you in the driver’s seat.
Otherwise, a seller faced with a choice between you and a pre-qualified buyer, will probably opt for the sure thing rather than wait for you to get your financing approved. Even if you make an offer first, your contingency offer could get bumped by an offer from a pre-approved, ready-to-roll buyer.
Your real estate agent can steer you to any number of sources for financing. Ask for a screening application with the prospective lender to determine the loan amount for which they will pre-qualify you.
