Buying a Home
Posted by Gail | Filed under Home Buying
A single mom wrote to me recently asking for some advice about buying a home. She wants to know how much she should put down, and how much she can reasonably afford to spend. While she’s been pre-approved for a mortgage – a good first step – she’s uncomfortable with the amount the lender seems willing to give her and wants to know what’s realistic.
Lenders use a calculation called debt service ratio to calculate how much they’ll lend you based on how much you can afford to repay each month. Gross Debt Service Ratio is the percentage of your gross annual income that it takes to cover payments associated with keeping a roof over your head: mortgage payments, property tax, heating, condo fees. Total Debt Service Ratio also takes into account other debt you may have like a car loan or lease and outstanding balances/limits on credit cards. Every lender has a limit for how much GDSR or TDSR is acceptable, generally been 32% and 40% respectively. However, for folks with very high credit scores, GDS requirements are often waived and the TDS maximum is often higher. This can get responsible borrowers into trouble because it means they can end up over-extending themselves.
Let’s use the gross debt service ratio of 32% as a starting point to determine how much you can afford. If you make $5,000 a month before taxes, 32% of that would be $1,600 a month, which is what the bank will say you can afford in mortgage payments. With an interest rate of 6%, amortized for 25 years, you could afford a mortgage of about $190,000. Add on your downpayment and violá, you’ve got the amount of house you can afford.
Now I say all this as a guide. And it’s a good guide. But since people are getting into houses today, who would never have qualified to buy five years ago, before you jump into the fray, you need to know the facts.
Let’s work with the following. Let’s assume you’re planning to take on a $250,000 mortgage and that current interest rates for a 5-year term are 5.34%.
First let’s look at how amortization affects your repayment of principal and interest costs over the five-year term.
Amortization Monthly Payment Principal Pd Interest Pd
15 $2,014 $62,589 $58,241
20 $1,689 $40,337 $61,004
25 $1,503 $27,579 $62,588
30 $1,385 $19,538 $63,586
The shorter your amortization, the higher your monthly payment and the faster your pay your mortgage off. Going from a 15-year to a 30-year amortization means you’ll pay off two-thirds LESS on your principal over that five-year term. So, over the life of the mortgage you’ll pay a whack-load more in interest. But you’ll have a lower monthly payment to deal with.
Now let’s turn to downpayment. If you buy a home with anything less than 20% down, you’re going to have to buy high-ratio mortgage insurance. This insurance premium is calculated as a percentage of the loan amount, and the percentage depends on the loan to value ratio. The higher the loan to value ratio – the amount your borrowing relative to the value of the home — the higher the premium cost. So the lower your downpayment the more expensive the insurance. How expensive?
If you put 15% down, your mortgage insurance premium will be 1.75% of the mortgage, or $4,375 on your $250,000 mortgage. But if you only put 5% down, your premium will be 2.75% or $6,875. This premium may be paid in cash (nobody does this) or added to the mortgage amount (making your mortgage even larger).
Ultimately, the amount of home you can afford to buy depends on how much you’re spending elsewhere in your life. If you have no student or consumer debt you can spend anywhere from 35-50% of your take-home pay on your shelter costs, assuming all your other costs are in line. Shelter costs include your mortgage payment, property taxes, insurance, utilities and maintenance. Your other costs include transportation: 15%, saving 10%, life (including things like food, daycare costs, and clothes) 25%.
Before you jump up and down clicking your heels together at how much mortgage you’ve been approved for, do the math for yourself: add up all your costs and figure out just how much YOU can actually afford to commit to a mortgage payment.
I’m not trying to scare y’all away from home ownership. I’m trying to impress upon you that home ownership is a BIG responsibility, not one to be taken on lightly. And I’m trying to show you that spending a little time saving for a downpayment makes way more sense than locking yourself into a mortgage payment that strangles your cash flow while paying exorbitant amounts in interest and insurance premiums.