Mortgage Guidelines That Make “Cents”
The true cost of homeownership goes far beyond a house’s asking price. Be prepared to fork over thousands of additional dollars in interest, closing costs, repairs, renovations, maintenance, insurance, utilities and more. Not to mention, it will of course cost money to furnish your home as well. (People aren’t lying when they say buying a home is likely the biggest purchase you’ll ever make!)
Obviously, you’ll want to ensure you can afford homeownership before you close on a mortgage. Here are some general rules to keep in mind:
To keep your purchase affordable, make sure your total monthly housing payment (including your mortgage, homeowner’s insurance, property taxes, etc.) doesn’t exceed 28% of your gross monthly income. (FYI: Gross monthly income is the amount you make before taxes are taken out.) If your annual household income is $90,000, for instance, divide that number by 12 to determine your gross monthly income. In this example, the gross monthly income is $7,500. Now, multiply that number by 0.28 to determine your maximum monthly housing payment, which equals $2,100 in this scenario.
Now that you know the maximum amount you should spend on your monthly housing payment, it’s time to factor your total debt into the equation. Experts recommend that your total monthly debt payments (including your mortgage and any other debts such as an auto loan or student loan) should not go beyond 36% of your gross monthly income. So don’t assume that if your annual household income is $90,000, you can automatically afford a total monthly housing payment of $2,100. Here’s an example to illustrate this point:
Based on the 36% rule (and assuming a $90,000 annual household income), the total amount of debt you should pay per month should max out at $2,700. If you pay $700 each month in other debts, then your total housing payment should not exceed $2,000 (to ensure you don’t go above your $2,700 maximum). Note that this is $100 less than the amount you might allow yourself to pay if you fail to take this second rule into account. Here’s how to do the calculation for your own situation: Simply divide your annual household income by 12 and multiply that number by 0.36. Then, subtract from that number all your other monthly debt payments. The number you’re left with is your maximum total housing payment per month.
The Low-Down on Down Payments
One of the most important financial decisions you’ll have to make early on in the home-buying process is determining how much of a down payment you can afford. Some lenders offer low or no down payment options, but putting down 20% of the home’s purchase price is ideal. If you put down less than 20%, you will need to pay PMI (Private Mortgage Insurance).
Loan Officers vs. Mortgage Brokers
If you’ve started researching the home-buying process, you’ve probably heard the terms “loan officer” and “mortgage broker.” These professionals play similar roles, but are fundamentally different:
- A loan officer is an individual who works directly for a bank or credit union and offers loans from the financial institution that employs them.
- A mortgage broker is not associated with a particular bank or credit union. Instead, they research loans from a number of different sources and enter into mortgage contracts with various lenders.
Pre-Qualification vs. Pre-Approval
Before beginning your house hunt, it’s a good idea to get pre-qualified or pre-approved for a mortgage. Doing so will give you an idea how much you can afford to spend so you won’t waste your time looking at houses that are out of your price range. Keep in mind, though, that pre-qualifications and pre-approvals are two very different things:
- Getting pre-qualified simply means that a lender has provided you with an estimate of the mortgage amount you will likely qualify for. If you choose to purchase a home, you will still have to go through the actual mortgage application process at that time.
- Getting pre-approval requires you to provide a lender with paperwork so they can verify your income, credit, etc. If that lender does decide to pre-approve you for a mortgage, it essentially means you are guaranteed to get a loan up to a specified amount (assuming no major financial changes occur) for a limited period of time.
When it Comes to Mortgages, One Size Does Not Fit All
Numerous options and programs exist with different terms, features and benefits to suit various buyers. Be a well-informed consumer by familiarizing yourself with these common mortgage types:
Conventional / Fixed-Rate Mortgage — A fixed-rate mortgage features an interest rate that remains constant throughout the term of the loan. Most fixed-rate mortgages come with a term of either 15 or 30 years.
Adjustable-Rate Mortgage (ARM) — Adjustable-rate mortgages typically start with a lower rate than fixed-rate mortgages, but after a few years the rate can begin to rise and will fluctuate periodically.
Low Down Payment with Private Mortgage Insurance (Up to 97% for qualified buyers) — These days, it’s not nearly as feasible as it used to be for borrowers to put 20% down on a home. There is a way to still buy a home with as little as 3% down – with Private Mortgage Insurance, or PMI. A protective measure for the lender, PMI asks the borrower to pay an insurance premium until the mortgage balance reaches 80% of the home’s value, in exchange for up to 97% financing.
Zero Down Mortgage (Up to 100% financing of purchase price for qualified buyers) — For some borrowers, limited cash on hand makes it impossible to come up with any down payment even though they may otherwise feel financially prepared for homeownership. A zero down mortgage covers up to 100% of the cost by combining a traditional first mortgage with a home equity loan.
Selecting the mortgage option that works best for you will depend on a number of factors, including how long you plan to stay in the home, if you’re comfortable not knowing what your future payments might be and more. Work with your loan officer or mortgage broker to discuss your goals and lifestyle in relation to these different financing options. By carefully analyzing the pros and cons of each loan type, you can determine a financing option that best meets your needs.