You have reflected upon the benefits of renting versus buying a home and made the choice. You have then selected a real estate agent to work with. The next decision is to define the price range in which you’ll focus your home search.
This leads to two questions: 1. What Can you Afford? And 2. How much should you spend? One is an economic question and the other, a philosophical one, I suppose. Let us address the easy one first.
What Can I Afford? This is the upper end of your affordability as defined by the lender. A conservative guideline followed by most lenders is the 28/36 debt ratio. They take your gross monthly income(before anything is taken out – this is the fantasy money) and multiply it by 36%. This will yield your maximum monthly debt payment one can have(includes housing debt, automobile debt/debts, credit card debt, student loan, personal loan, etc.). As for the housing debt service itself, the monthly payment which includes principle, interest, real estate taxes, home owners’ insurance and private mortgage insurance if applicable, it cannot exceed 28% of your gross monthly income. That is if your other debts don’t exceed 8% of your gross monthly income
Let us use some real numbers to clarify the above ratios. Let us say your monthly gross income is $5000. You have a car payment of $360, student loan payments of $60, a credit card payment(minimum payment) of $40. That is 9.2% of your gross monthly income. In this situation, your housing debt payment cannot be more than $1,340 per month. This is not set in stone. Depending on potential future income growth, the quality of credit history, etc., the lender could look at debt ratio as high as 30/41% - sometimes even higher.
Once you have determined the upper threshold of affordability, you then have to make the philosophical decision of where you would be comfortable. Look at your lifestyle needs, your near term future expenses that may be lurking such as needing a new car or making a trip to India, etc and then determine your comfort zone – a price range in which you can breathe easily and every unexpected expense won’t send you into convulsions! The goal is not to become house poor. Maintain a balance among various needs.
Once this is done, you want to go through the process of getting pre approval from a lender. This will accomplish two things: 1. it’ll confirm formally that you can, in fact, afford what you think you can afford and 2. when you do find a home and write an offer, the seller will look at your offer more seriously because your offer is a better risk than an offer from a prospect who is not pre approved. It gives you a bit of leverage. Also, it eliminates disappointments that may crop up if there is any discrepancy between your computations and the lenders’ decision.
The terms ‘pre-qualification’ and pre-approval’ are often used loosely as if they mean the same. They do not. Pre Qualification is a process where you provide all the pertinent financial information(your employment history, your earnings, your debts, etc.) to the lender and the lender pre qualifies you for a certain loan amount based on the information you have provided. However, in the pre approval process, the lender gathers the same information from you but goes through the process of verifying this information in writing from the various sources and based on this verification and confirmation pre approves you for a certain loan amount. The pre qualification is just a guideline whereas the pre approval leaves no room for uncertainty.
In short, you should get pre approved before or as soon as you begin your search. Some lenders don’t charge a fee for this service and some charge a small amount - $20 to $40 to obtain the credit report. This pre approval is usually good for 90 days. After that they just have to re verify the information.
Other financing decisions to be made are fixed versus variable rate mortgages, 15-yr. Vs. 30-yr. Mortgages, the amount of down payment, the lender to use, etc. Let us focus on the nuts and bolts of Mortgages in the next issue.
What Can I Afford? This is the upper end of your affordability as defined by the lender. A conservative guideline followed by most lenders is the 28/36 debt ratio. They take your gross monthly income(before anything is taken out – this is the fantasy money) and multiply it by 36%. This will yield your maximum monthly debt payment one can have(includes housing debt, automobile debt/debts, credit card debt, student loan, personal loan, etc.). As for the housing debt service itself, the monthly payment which includes principle, interest, real estate taxes, home owners’ insurance and private mortgage insurance if applicable, it cannot exceed 28% of your gross monthly income. That is if your other debts don’t exceed 8% of your gross monthly income
Let us use some real numbers to clarify the above ratios. Let us say your monthly gross income is $5000. You have a car payment of $360, student loan payments of $60, a credit card payment(minimum payment) of $40. That is 9.2% of your gross monthly income. In this situation, your housing debt payment cannot be more than $1,340 per month. This is not set in stone. Depending on potential future income growth, the quality of credit history, etc., the lender could look at debt ratio as high as 30/41% - sometimes even higher.
Once you have determined the upper threshold of affordability, you then have to make the philosophical decision of where you would be comfortable. Look at your lifestyle needs, your near term future expenses that may be lurking such as needing a new car or making a trip to India, etc and then determine your comfort zone – a price range in which you can breathe easily and every unexpected expense won’t send you into convulsions! The goal is not to become house poor. Maintain a balance among various needs.
Once this is done, you want to go through the process of getting pre approval from a lender. This will accomplish two things: 1. it’ll confirm formally that you can, in fact, afford what you think you can afford and 2. when you do find a home and write an offer, the seller will look at your offer more seriously because your offer is a better risk than an offer from a prospect who is not pre approved. It gives you a bit of leverage. Also, it eliminates disappointments that may crop up if there is any discrepancy between your computations and the lenders’ decision.
