When you’re planning to buy a home, one of the first things you need to do is map out your budget. Knowing how large of a mortgage you can comfortably take on and what the other upfront and ongoing costs you’ll need to plan for can help you form a framework for your house hunt.
As part of the initial home-buying process, you may be encouraged to get pre-approved for a loan. While this can give you an idea of how much a bank is willing to lend, it’s not necessarily the most accurate way to gauge what you should actually pay for a home. Taking a look at how your pre-approval matches up with what you can afford can keep you from getting in over your head with mortgage debt.
How Mortgage Pre-Approval Works
Mortgage pre-approval is a precursor of sorts to getting a home loan and it’s helpful to go through the process before you begin looking at homes. During the pre-approval stage, the lender performs many of the same steps that are required to underwrite a loan once you’ve been approved.
For example, you’ll have to fill out a mortgage application and the lender will ask to see certain financial documentation, such as copies of your pay stubs, tax returns and bank statements. The bank will also take a close look at your credit history to see how good you are keeping up with your bills, how much debt you’re carrying and whether you have any serious negative marks, such as collection accounts, charge-offs or bankruptcy.
Once you’ve jumped through all of the requisite hoops, you’ll be given a specific dollar amount of how much the bank is willing to lend you. The lender may also give you a ballpark estimate of the kind of interest rate you’ll pay based on your credit history and score. The quoted loan amount is usually only good for a set period of time and if you move forward with a mortgage, the amount you’re approved for can change.
Pre-Approval vs. Pre-Qualification
Pre-approval and pre-qualification are often lumped together into the same basket but they’re two very different things and it’s important to understand the difference if you’re serious about buying a home. Pre-approval is a much more intensive process that’s designed to allow you to pin down how much home you can buy.
Pre-qualification, on the other hand, isn’t as complex. Generally, the lender looks at your income, debt and assets and uses that information to give you an approximation of what you might be able to get approved for. Pre-qualification can be done over the phone and there’s usually no paperwork involved, nor are you expected to complete a credit check.
If you’re gearing up to buy a home, pre-approval can paint a more accurate picture of what you’ll be able to borrow. It also tells sellers that you’re serious about buying since you’ve already got a lender ready to back you financially. If you’re making an offer on a home with just a pre-qualification, the seller may pass you up in favor of someone who’s already considered to be a lock for a loan.
Why You Shouldn’t Bank on Pre-Approval
One of the most common mistakes you can make as a home-buyer is assuming that because you’re approved for a certain loan amount that you can actually afford to take on a mortgage of that size. That’s a problem, however, because mortgage pre-approval only takes a limited set of factors into account.
With pre-approval, the lender is focusing primarily on how much money you’re bringing and what your credit history looks like. Your monthly debt payments also come into play but the lender may not be giving weight to things like how much you’re spending on groceries each month or what your expected maintenance costs for the home will be.
Pre-approval can also create issues if your income fluctuates. If you freelance, for example, you may not be making the same from one month to the next. Opting to buy a more expensive home because you were able to get approved for a bigger mortgage based on how much you average each year can come back to bite you if your income takes a sudden dive.
Adding Up the Cost of Buying
While getting pre-approved for a mortgage can give you a sense of what price range you should be looking in, it’s not a substitute for a carefully planned home-buying budget. To figure out how much you can afford to spend, it helps to break it down into upfront and ongoing costs.
In terms of what you’ll pay upfront, there are three figures to focus on. The first and potentially the largest cost is your down payment.
If you’re planning to go the conventional loan route, you’ll need to bring 20 percent or more to the table to avoid paying private mortgage insurance. Private mortgage insurance is required when the loan-to-value ratio is 80 percent or higher and it can add hundreds of dollars on to your monthly payments.
If you’re planning to apply for an FHA loan, the down payment requirement drops to 3.5 percent of the purchase price. There’s an exception, however, if your credit score is below 580. In that scenario, you’d need to put at least 10 percent down to qualify for a mortgage.
Next, you’ll have to factor in the earnest money deposit that’s required after you’ve made an offer. Also known as a good faith deposit, this is a set amount of cash you hand over to the seller to show them that you’re committed to closing the deal. Typically, buyers are expected to put up between 1 and 3 percent of the purchase price in earnest money.
Finally, there are the other closing costs to consider. This includes things like the loan origination fee, inspection fees, attorneys’ fees, mailing fees, title insurance and any other expenses associated with finalizing your loan. Closing costs can run between 2 and 5 percent of the purchase price. With a $250,000 mortgage, for example, you’d be looking at anywhere from $5,000 to $12,500 to close.
Your mortgage payment is the most important ongoing cost you need to plan for when buying home and there are a couple of things that can influence how much you’ll pay. The first is the interest rate. The higher your rate is, the higher your monthly payments will be.
Here’s an example. Let’s say you’re taking out a $250,000 mortgage at 4 percent. On a 30-year loan, your monthly payments would be just shy of $1,200. If you lock in a rate of 4.5 percent, on the other hand, your payments would climb to $1,267 a month.
Next, you’ve got to factor in whether you’re paying private mortgage insurance. If you’ve put down at least 20 percent this won’t be an issue but if not, you need to understand how that can affect your payments. Using the numbers in the previous example, PMI would increase your payments by just over $100 a month.
With FHA loans, mortgage insurance is handled a little differently. Borrowers pay a one-time upfront mortgage insurance premium, which is currently set at 1.75 percent of the base loan amount, as well as an annual mortgage insurance premium. The annual premium for loans originated after January 2015 is set at 0.85 percent.
Private mortgage insurance can be removed once you reach a loan to value ratio of 78 percent on a conventional loan. If you’re getting an FHA loan, whether or not you can eliminate the annual mortgage insurance premiums at some point depends on the length of the loan term and how much you put down.
The next category of expenses includes things like property taxes, homeowners’ insurance and HOA fees if you’ll be living in a planned community. Together, these can add a few thousand dollars on to your housing budget for the year. You also have to take into account things like utilities, repairs, maintenance and renovations if you’re planning to make some upgrades once you move in.
Calculating How Much Home You Can Afford
Now that you know what it means to be pre-approved for a mortgage and what the different costs are associated with buying and owning a home, it’s time to figure out what you can legitimately afford to spend. There are two formulas that can help you to zero in on a number.
First, you’ll want to calculate your housing expense ratio. This is the amount of your monthly income that you can reasonably expect to spend on your mortgage principal, interest, taxes, insurance and HOA fees if applicable. Ideally, lenders want your total housing expense to add up to 28 percent or less of your monthly income.
So for example, if you bring in $5,000 a month, you could theoretically afford to spend $1,400 of that on a home. This is only part of the equation, however. You also have to crunch the numbers to figure out your debt to income ratio. This is the amount you’re spending each month on housing combined with payments for other debts, such as student loans or credit cards. The target ratio here is 36 percent or less.
Going back to the previous example, a 36 percent debt ratio on a $5,000 monthly income would equal $1,800. Assuming you’re spending $800 a month on paying your other debts, that would knock the amount you could afford to spend on housing down to $1,000. If the homes you’re looking at are above that cutoff, you’d have to work on paying down your debts to free up extra cash.
Keep in mind that this ratio takes into accounts debt you have in your name, even if you’re not actually paying on them. If you co-signed on a loan for someone, for instance, you’d have to be able to prove to the lender that your co-borrower is making those payments. Otherwise, that could inflate your debt to income ratio and affect your ability to get a loan.
These ratios are typical of what lenders use but depending on which bank you plan to get a mortgage from, the ratios may be higher or lower. Using these numbers as a guideline is a good way to hedge your bets, however, because it can prevent you from overreaching for a loan that’s outside the scope of your budget.
Figuring Out Home Affordability With an Irregular Income
When your paycheck isn’t consistent from month to month, figuring out your housing and debt ratios may be a little trickier. The easiest approach is to determine what you’re bringing in on average each month and use that number to calculate each ratio. If you’re just basing it on your highest month’s pay, that’s going to give you an inflated sense of what you can afford.
If you’re self-employed, you’ll want to base your calculations on your net income rather than your gross. That means subtracting things like estimated quarterly tax payments, insurance and any expenses you pay in connection with your business. Using your gross income to run the numbers will skew the end result.
The Bottom Line
Buying a house is a huge financial commitment and there’s no room for error when it comes to figuring out your mortgage affordability. The fallout from the housing crisis is a perfect example of what can happen when home-buyers take on loans that aren’t appropriate for their budget situation. A mortgage pre-approval can be a useful tool in more ways than one but it’s not a one-size-fits-all proposition where home-buying is concerned.
Each buyer’s financial situation is different and accepting a pre-approval at face value can be a major stumbling block down the line. Taking the time to drill down a more specific idea of what you can afford based on your income, your other debts and what you’ll need to spend up front can steer you towards a home without fear of putting an unnecessary strain on your wallet.
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