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Mortgages For Dummies
By Eric Tyson Ray Brown
John Wiley & SonsISBN: 0-7645-7192-3
Chapter OneDetermining Your Borrowing Power
In This Chapter
* Understanding how much mortgage debt you can truly afford
* Examining your monthly spending
* Assessing your likely homeownership expenses
* Considering your other financial goals
Do you feel less than fully informed about mortgages and related housing decisions? Well, you have lots of company. However, you are in a minority of people who recognize the gaps in their mortgage knowledge, and who are willing to invest a little of their time and money to get smarter. We know that much about you because you're reading this book.
You've made a wise decision to improve your mortgage and real estate wisdom. If Ken and Mary had done the same, they could have avoided some costly mistakes we know you won't make. Here, briefly, are their tales of woe.
Mary was a first-time home buyer. She began going to open houses on Sunday afternoons and, in a relatively short time, fell in love with a home. Unfortunately, she had to mortgage herself up to her eyeballs to get into it.
Not thrilled with her job, Mary continued to tough it out because she had that hefty mortgage to feed every month. She had to cut out travel and restaurant dinners with friends. Mary was miserable. To cheer herself up, she started charging more on her credit card. The spending hangover that hit when her next credit card statementarrived made the enjoyment short lived.
Ken was a homeowner who was induced by an advertisement to refinance. He switched adjustable-rate mortgages without understanding how long it would take him to recoup the associated financing costs (nearly 10 years, which was longer than Ken intended to keep his home).
The main reason Ken refinanced was that his previous adjustable-rate loan's interest rate increased rapidly when the adjustment index it was tied to rose sharply. A mortgage broker put Ken into an adjustable-rate mortgage with a much slower moving index right before rates started back down. He thus switched out of a faster moving loan after rates popped up, and he wasn't able to benefit nearly as fast when rates fell.
Now, trust us when we say that Ken and Mary aren't stupid. However, when it came to making important mortgage decisions, Ken and Mary were certainly not smart. Mary didn't understand what amount of mortgage debt she could truly afford. Ken didn't understand how to make refinancing decisions.
In this chapter, we help you tackle the first vital subject to consider when the time comes to take out a mortgage - how much mortgage can you really afford? Note: We intend this chapter primarily to help people who are buying a home (first or not) determine what size mortgage fits their financial situation. If you're in the mortgage market for purposes of refinancing, please also see Chapter 11.
Only You Can Determine the Mortgage Debt You Can Afford
Sit down and talk in person, by phone, or on a Web site with any mortgage lender, mortgage broker, or real estate agent, and you'll be asked about your income and debts. Assuming you have a good credit history and an adequate cash down payment, the lender can quickly estimate the amount of mortgage debt you can obtain.
Suppose a mortgage lender says that you qualify to borrow, for example, $150,000. What a lender is basically telling you when it says it will lend you $150,000 is that, based on the assessment of your financial situation, $150,000 is the maximum amount that this lender thinks you can borrow on a mortgage before putting yourself at significantly increased risk of default. Don't assume that the lender is saying that you can afford to carry that much mortgage debt given your other financial goals.
Your personal financial situation, most of which lenders, mortgage brokers, and real estate agents won't inquire into or care about, should help direct how much you borrow. For example, have you considered and planned for your retirement goals? Do you know how much you're spending per month now and how much slack, if any, you have for additional housing expenses including a larger mortgage? How are you going to pay for college expenses for your kids?
Scrutinize Your Monthly Spending
Unless you have generous parents, grandparents, or in-laws, if you want to buy a home, you need to save money. The same may be true if you desire to trade up to a more costly property. In either case, you can find yourself taking on more mortgage debt than you ever dreamed possible.
After you trade up or buy your first home, your total monthly expenditures will surely increase. Be forewarned that if you had trouble saving before the purchase, your finances are truly going to be squeezed after the purchase. This pinch will further handicap your ability to accomplish other important financial goals, such as saving for retirement, starting your own business, or helping to pay for your children's college education.
Because you can't manage the unknown, the first step in assessing your ability to afford a given mortgage amount is to collect and analyze your monthly spending. If you already track such data - whether by pencil and paper or on your lightning-quick, six-gazillion-megahertz computer, you have a head start. But don't think you're finished. Having your spending data is only half the battle. You also need to know how to analyze your spending data (which we explain how to do in this chapter) to help decide how much you can afford to borrow.
Collect Your Spending Data
What could be more dreadful than sitting at home on a beautiful sunny day - or staying in at night while your friends and family are out frolicking on the town - and cozying up to your calculator, checkbook register, credit card bills, pay stub, and most recent tax return?
Examining where and how much you spend on various items is almost no one's definition of a good time (except, perhaps, for some accountants, actuaries, and other bean counters who crunch numbers for a living). However, if you don't endure some pain and discomfort now, you could end up suffering long-term pain and discomfort when you get in over your head with a mortgage you can't afford.
Now some good news: You don't need to detail to the penny where your money goes. What you're interested in here is capturing the bulk of your expenditures. Ideally, you should collect spending data for a three- to six-month period to determine how much you spend in a typical month on taxes, clothing, meals out, and so forth. If your expenditures fluctuate greatly throughout the year, you may need to examine a full 12 months of your spending to obtain an accurate monthly average.
Later in this chapter, we provide a handy table that you can use to categorize your spending. First, however, we need to talk you through the specific and often large expenses of owning a home so that you can intelligently plug those into your current budget.
Determine Your Potential Homeownership Expenses
If you're in the market to buy your first home, you probably don't have a clear sense about the costs of homeownership. Even people who presently own a home and are considering trading up often don't have a good handle on their current or likely future homeownership expenses. So we included this section to help you assess your likely homeownership costs.
As we discuss in detail in Chapter 4, a mortgage is a loan you take out to finance the purchase of a home. Mortgage loans are generally paid in monthly installments over either a 15- or 30-year time span.
In the early years of repaying your mortgage, nearly all of your mortgage payment goes toward paying interest on the money that you borrowed. Not until the later years of your mortgage do you begin to rapidly pay down your loan balance (the principal).
As we say earlier in this chapter, all that mortgage lenders can do is tell you their own criteria for approving and denying mortgage applications and calculating the maximum that you're eligible to borrow. A mortgage lender tallies up your monthly housing expense, the components of which the lender considers to be the mortgage payment, property taxes, and homeowners insurance.
Understanding lenders' ratios
For a given property that you're considering buying, a mortgage lender calculates the housing expense and normally requires that it not exceed 40 percent or so of your monthly before-tax (gross) income. So, for example, if your monthly gross income is $6,000, your lender may not allow your expected monthly housing expense to exceed $2,400. If you're self-employed and complete IRS Form 1040, Schedule C, mortgage lenders use your after-expenses (net) income, from the bottom line of Schedule C (and, in fact, add back non-cash expenses for items such as depreciation, which increases a self-employed person's net income for qualification purposes).
This housing expense ratio completely ignores almost all your other financial goals, needs, and obligations. It also ignores property maintenance and remodeling expenses, which can suck up a lot of a homeowner's dough. Never assume that the amount a lender is willing to lend you is the amount you can truly afford.
In addition to your income, the only other financial considerations a lender takes into account are your debts. Specifically, mortgage lenders examine the required monthly payments for other debts you may have, such as student loans, auto loans, and credit card bills. In addition to the percentage of your income that lenders allow for housing expenses, they typically allow an additional 5 percent of your monthly income to go toward other debt repayments.
Calculating your mortgage payment amount
After you know the amount you want to borrow, calculating the size of your mortgage payment is straightforward. The challenge is figuring how much you can comfortably afford to borrow given your other financial goals. This chapter should assist you in this regard, especially the previous section on analyzing your spending and goals.
Suppose that you worked through your budget and determined that you can afford to spend $2,000 per month on housing. Determining the exact size of mortgage that allows you to stay within this boundary may seem daunting, because your overall housing cost is comprised of several components: mortgage payments, property taxes, insurance, and maintenance.
Using Appendix A, you can calculate the size of your mortgage payments based on the amount you want to borrow, the loan's interest rate, and whether you want a 15- or 30-year mortgage.
As you're already painfully aware if you're a homeowner now, you must pay property taxes to your local government. The taxes are generally paid to a division typically called the County or Town Tax Collector. (If you make a smaller down payment - less than 20 percent of the home's purchase price - you may have an impound account. Such an account requires you to pay your property taxes, and often your homeowners insurance, to the lender each month along with your mortgage payment. The lender is responsible for making the necessary property tax and insurance payments to the appropriate agencies on your behalf.)
Property taxes are typically based on the value of a property. Because property taxes vary from one locality to another, call the relevant local tax collector's office to determine the exact rate in your area. (You should be able to find the phone number in the government section of your local phone directory.) In addition to inquiring about the property tax rate in the town where you're contemplating buying a home, also ask what additional fees and assessments may apply.
As you shop for a home, be aware that real estate listings frequently contain information regarding the amount the current property owner is currently paying in taxes. These taxes are often based upon an outdated, much lower property valuation. If you purchase the home, your property taxes may be significantly increased based on the price that you pay for the property.
Tax write offs
This is a good point to pause, recognize, and give thanks for the tax benefits of homeownership. The federal tax authorities at the Internal Revenue Service (IRS) and most state governments allow you to deduct, within certain limits, mortgage interest and property taxes when you file your annual income tax return.
You may deduct the interest on the first $1,000,000 of mortgage debt as well as all the property taxes. (This mortgage interest deductibility covers debt on both your primary residence and a second residence.) The IRS also allows you to deduct the interest costs on second mortgages known as home equity loans or home equity lines of credit, HELOCS, (see Chapter 6) to a maximum of $100,000 borrowed.
To keep things simple and get a reliable estimate of the tax savings from your mortgage interest and property tax write off, multiply your mortgage payment and property taxes by your federal income tax rate in Table 1-1. This approximation method works fine as long as you're in the earlier years of paying off your mortgage, because the small portion of your mortgage payment that isn't deductible (because it is for the loan repayment) approximately offsets the overlooked state tax savings.
When you own a home with a mortgage, your mortgage lender will insist as a condition of funding your loan that you have adequate homeowners insurance. The cost of your insurance policy is largely derived from the estimated cost of rebuilding your home. Although land has value, it doesn't need to be insured, because it wouldn't be destroyed in a fire. Buy the most comprehensive homeowners insurance coverage you can and take the highest deductible that you can afford, to help minimize the cost.
As a homeowner, you'd also be wise to obtain insurance coverage against possible damage, destruction, or theft of personal property such as clothing, furniture, kitchen appliances, audiovisual equipment, and your collection of vintage fire hydrants. Personal property goodies can cost big bucks to replace.
In years past, various lenders learned the hard way that some homeowners with little financial stake in the property and insufficient insurance coverage simply walked away from homes that were total losses and left the lender with the loss. Thus, nearly all lenders, especially those that sell mortgage loans in the financial markets, now require you to purchase private mortgage insurance if you put down less than 20 percent of the purchase price when you buy.
You can avoid paying private mortgage insurance by using 80-10-10 financing. We cover this delightful technique in Chapter 6.
Excerpted from Mortgages For Dummies by Eric Tyson Ray Brown Excerpted by permission.
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