The largest single purchase that most families make
is a house. The thing most likely to get families into financial
trouble is overspending on housing. Trying to live in a house
you can't afford will squeeze every other area of your budget. The most frequently asked question:
how can I decide
how much house I can afford to purchase? The warning I give is that
if you don't compute what you can afford BEFORE you go house hunting,
it is almost guaranteed that you will purchase too much house, putting
your personal finances in a bind. This is a very common
mistake made by prospective home buyers when they let the bank/lending
institution qualify them for what they can afford. REMEMBER...THEY
ARE IN THE BUSINESS OF SELLING DEBT! They will qualify you for
as much as possible (usually 28-36% of your gross pay, and in some cases as
high as 50% or more). That amount will far exceed the amount that will allow you to have a workable budget and
continue to save money monthly. There is no better time than now to see
what happens when a person fails to do his/her homework. Please take a
minute and read this short page (over and over if necessary). Don't make
the mistake that millions have made. DO YOUR HOMEWORK!
One last note: be sure that you understand the details of your loan. Be cautious of deceptive lending practices such as equity stripping, loan flipping, hiding loan terms and packing a loan with extra charges.
An interesting statistic: "About
30% of the households in America that live in homes valued at $300,000
have annual household earned incomes of $60,000 or less." The Millionaire Next Door.
In the news: Housing prices fall by a record
and Foreclosures are not letting up.
Data from the 2000 Census: (see more on the Financial Statistics page)
FAQs
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Should I pay someone to set me up on a bi-weekly payment schedule?
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How do I prove that I am credit worthy without getting a credit card?
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How does bankruptcy affect my ability to get a mortgage loan?
Home prices were down 10% through the fourth quarter from their peak in mid-2006, according to the S&P/Case-Shiller national home-price index. But to bring prices in line with incomes, they will need to fall further. If incomes continue to grow in the next year as they have in the past decade — probably an optimistic assumption — it would take a 9% to 12% drop in home prices to bring the two measures in line with each other.
A house is the most expensive purchase that most people
will ever make. The total monthly expense required to purchase and
maintain a house, accounts for the largest single line item in the personal
budget. When too much house is purchased, it has the potential to
wreck a family's financial situation. It is therefore imperative
that you accurately calculate how much house you can afford BEFORE
you go house hunting. I will show you how to do this in this
section.
In the classical scenario, a couple (or single person) will initiate their search for the single family home based on emotions and hope. Dreams of a comfortable nest that they can call their own and be proud of and the hope that the bank will lend them the money to make it all come true is usually justification enough to call a realtor and begin the hunt. The realtor will attempt to size up your interest, desires and financial capabilities and direct you towards your maximum potential (remember, the realtor gets paid a % of the purchase price). The lending institution will also attempt to "size you up" for the maximum loan possible even if the fit is more like a chain and ball (remember, the lending institution is SELLING debt).
The cute little story about house hunting ends with a beautiful house being SOLD (as apposed to being bought) to a poorly prepared buyer with a monthly payment for principal, interest, taxes and insurance (PITI) that is at the absolute maximum. Then comes "the rest of the story....". The next step is to personalize and equip our little castle with window coverings, furniture, lawn equipment, landscaping, etc., etc. Having barely been able to scrape up a small down payment, the only possible way to pay for all this extra stuff is with debt (credit cards). Oh but don't worry, we BOTH expect to get raises soon and that annual bonus is only a few months away. And the story goes on with many unexpected financial surprises which result in stress and argument that quickly turns the castle into a dungeon (go check out the video "Money Pit" for a comical view of this serious problem).
So what is the solution? The first step is to develop a monthly budget and calculate how much you can really afford to pay. Start your house hunting journey equipped with the knowledge of what will work for you and hire a realtor that will work for you not against you. When the journey comes to an end, you will be proud that you made a wise purchase and a good investment that you can afford. As your financial situation improves, you will be able to build strength and move up in housing if you so desire. You must take control rather than letting those who are NOT concerned about your financial future use you to make their lives better.
The standard loan limit debt ratio, calculated as a percentage of your GROSS income, is 28-36% for conventional loans and 28-41% for FHA loans. I highlight gross income because if you are inclined to make charitable contributions or pretax savings then you will come to find that the standard loan limits could result in your financial demise. I should also point out that with excellent credit and the use of automated underwriting, loan limit ratios can be as high as 50% of your GROSS income. Some call this the 28/36 or 28/41 rule of thumb. The first number, 28 in both cases, tells you how much of your gross monthly income can be used for principle, interest, taxes and insurance, or what's often called PITI. And the second number, 36 on the conventional and 41 on FHA loans, is the percentage allowed for all of your debt -- that's your PITI plus car payments, student loans, credit cards and the rest (and in some cases 50%). Anyway you slice it, 28, 36, 41, or the ridiculous 50 percent of your GROSS income are all more than you can afford if you want to have a workable budget.
The number you must focus on for all calculations is Net Spendable Income (NSI) or take home pay, not GROSS. This is the amount that remains after all taxes, contributions, and pretax withdrawals have been made. You can only spend 100% of your NSI (take home pay) each month and no more.
I recommend the
HOUSE category to be limited to 30-40% of NSI. When 40% is
exceeded you will have difficulty making a budget work. When the
total percentage for the big three (house, food, auto) exceeds 65%
of your N.S.I. your budget will usually not work. I would
start with 25-30% for PITI and 5-10% for other HOUSE items such
as utilities, lawn care, maintenance and other HOUSE related
expenditures. Below is a visual example of what a month might look
like.
| GROSS INCOME | 100% | $5,000 |
| Charitable Giving | 10% | $500 |
| Taxes | 25% | $1,250 |
| Pre-tax savings | 10% | $500 |
| N.S.I. | 100% | $2,750 |
| Savings | 5% | $137.50 |
| House | 37% | $1,0175 |
| Food | 15% | $412.50 |
| Auto | 10% | $275 |
| Clothing | 5% | $137.50 |
| Medical/Dental/Health | 5% | $137.50 |
| Life Insurance | 2% | $55 |
| Personal | 15% | $412.50 |
| Entertainment/Recreation | 4% | $110 |
| Debts | 0% | $0 |
| Other | 2% | $55 |
| BALANCE | 0% | $0 |
Notice that there is no debt payment required in the debt line and there is pretax and after tax savings with all categories funded. Without DEBTs, you can have a life that works (see the section on DEBT). I must point out that the AUTO line is used for monthly auto expenses only not for debt service requirements on an auto loan. Auto debt payments would be listed with all other consumer debts on the DEBTS line (see the BUDGET section for more details about budgeting).
Look around. Many of the housing troubles in our country today are the result of easy credit and a lack of planning and discipline; people who failed to do some simple planning. It should be a warning to you that when the HOUSE category grows too large, the other categories in your budget will suffer and probably not get funded at all. Don't fool yourself into believing you can live like that for long because you can't. Just for fun, calculate a standard loan limit of 28-36% of the GROSS income for the example above and see how that would affect the overall budget.
In the above example the total HOUSE budget is 37% ($1,0175). If you used 7% ($192.50) for utilities, repairs, upkeep and misc., that would leave you with 30% ($825) for PITI. I know what you are probably saying, "That sure doesn't buy much house". Your right and that is a budget with "0" debt and only a small savings plan. The key here is to let you see reality. An annual income of $60,000 ($5,000 pre-tax per month) has limitations as does any income. It's all relative. Below is an idea of what the payment (Principle and Interest only) would be for a few example loans. Taxes and Insurance will vary and are therefore not included in the chart.
|
Loan Amount |
Interest Rate | Term | Payment |
| $80,000 | 7% | 30 yrs | $532 |
| $90,000 | 7% | 30 yrs | $599 |
| $100,000 | 7% | 30 yrs | $665 |
| $125,000 | 7% | 30 yrs | $831 |
| $150,000 | 7% | 30 yrs | $998 |
| $175,000 | 7% | 30 yrs | $1,164 |
| $200,000 | 7% | 30 yrs | $1,331 |
| $250,000 | 7% | 30 yrs | $1,663 |
| $300,000 | 7% | 30 yrs | $1,996 |
The bottom line is that you MUST be disciplined to calculate the amount of HOUSE you can afford BEFORE you go shopping. It will make the difference between having a life or being HOUSE poor!
In our debt ridden society, very few people are able to put their hands on a large amount of cash. If asked to write a check for $1,000, the majority of Americans could not do it. Mortgage lenders know this and have devised several ways to get your debt business even though you are low on cash for a down payment. Down payments range from 0% to 20% or more. These loans are available in all forms and formats. But again, I remind you that lenders and banks are in the business of selling debt. Be disciplined enough to know when the time is right for you to buy that house based on a solid financial plan.
When a mortgage lender allows you to borrow a large percentage of the total value of the house you are purchasing (more than 80%), they require you to pay for insurance that will protect them in the event that you default on the loan. This default insurance is called Private Mortgage Insurance (PMI). If however your down payment is 20% or greater, then you are not required to purchase PMI. PMI insurance typically cost approximately $75/month per $100,000 borrowed or 1/2% to 1%. For example, PMI would be approximately $500 to $1,000 per year for each $100,000 borrowed.
The only way to have the PMI dropped from your monthly payments once it has been added is to prove to the lender that the amount owed on your house is equal to or less than 80% of the current market value (this is referred to as a loan to value of 20%). This can be done with a new appraisal of your property. The time required to build the required 20% equity will depend on the amount of your original down payment, the amount paid on the principle balance of the loan and the appreciation/depreciation of your house since it was purchased (see HOUSE links for details).
But leave it to those who make their living selling DEBT to devise a way to offer you the deal of a lifetime. Let's assume you have no money to put down as a down payment and you were really hoping to avoid the additional PMI. charge. Well, have the lenders got a deal for you. Would you believe nothing down and no down payment? That's right! The lenders quickly found out that if they were going to continue to grow their debt businesses in a society filled with broke people, they had to figure out something. If they lend you 80% on a first mortgage and 10-15% (and in some cases 20%) on a second mortgage then neither mortgage would be in excess of the 80% loan limit making PMI unnecessary. But this wonderful service is not without additional cost. You can count on the first mortgage being about 1% higher than normal rates and the second being approximately 3% higher. There are numerous combinations of mortgage arrangements - 80-10-10, 80-15-5, 80-20, etc. The debt sellers aim to please.
Visual Comparison
|
Item |
Recommended |
Mortgage Lender |
| Combined Income | $50,000/yr | $50,000/yr |
| Tithe | $5,000/yr | $5,000/yr |
| Estimated Taxes | $11,000/yr | $11,000/yr |
| Net Spendable Income | $34,000/yr | $34,000/yr |
| House Budget (P.I.T.I.) | $700/mo (25% of NSI) | $1,500/mo (36% of Gross) |
| Total House Budget | $1,000/mo (35% of NSI) | $1,800/mo (64% of NSI) |
Note: The estimate for other than PITI. used in the example above is $300/mo.
The above illustration shows that the bank will qualify you for way more than you should borrow to finance a mortgage. Remember, they are SELLING debt. At 64% of your NSI, you have reached the max recommended for the BIG THREE (House, Auto, Food) with HOUSE alone.
If at all possible I strongly recommend that you wait until you have a 20% down payment prior to taking out a mortgage loan. It is one more step in the right direction and proving to yourself that you are in control. Be patient!
I recommend that when you first start to crunch the numbers that you start with a term of 15 years. This will insure that your house debt is retired in time to make some serious progress towards long term savings goals. It will also allow for a more comfortable standard of living. If your HOUSE needs are large and income low then you might be required to opt for a 30 year term with a plan to make additional payments as your income allows. This of course requires extreme discipline for most and without a monthly budget it will be next to impossible.
How does a 15 year term vary from a 30 year term? The interest rate on a 15 year term will usually be lower (approximately 1/2 % lower than a 30 year) and the monthly payments will increase by only about 20-30%. The total amount paid on a 15 year will be considerable less than a 30 year. Below is a chart of the differences.
| LOAN | TERM | RATE | PAYMENT | TOTAL PAID |
| $100,000 | 30 YEAR | 7 % | $665 | $239,400 |
| $100,000 | 15 YEAR | 6.5 % | $871 | $156,780 |
| DIFF = | -15 YEARS | -.5 % | +$206 | -$82,620 |
A $200 increase in your monthly payment results in an overall savings of over $80,000! That's not too bad.
Using my Mortgage Analyzer, you can see if a 15 year mortgage verses a 30 year mortgage would result in a larger investment return by inserting a few key variables (interest rate on loans, loan amount, projected rate of return for investments, your tax rate). The most important variable in the equation is the projected average annual rate of return on your investments. BE ADVISED THAT THERE IS ALWAYS RISK IN ANY INVESTMENT AND THE RETURN RATES THAT YOU PROJECT ARE SUBJECT TO THAT RISK WHEREAS THE REALIZED RETURN RATE THAT YOU GET FROM PAYING OFF YOUR MORTGAGE HAS NO RISK! (click here to download a copy of my Mortgage Analyzer - requires MS Excel)
We live in a society that considers debt to be normal and is willing to accept the longest term possible. Just to give you a comparison as to how our society has changed, in 1929, 2% of the American homes were mortgaged while 98% were owned without debt. By 1962, 98% were mortgaged with only 2% being owned debt free.
The question always comes up, "what about the tax write off that I get from my mortgage loan?" The first rule to live by is "NEVER KEEP AN EXISTING DEBT BASED SOLELY ON THE TAX CONSEQUENCES". Sure, the small tax deduction you get is a great thing but it does not justify keeping the debt.
Many people don't understand how the tax savings is computed on allowed deductions. Let me explain. Assume your mortgage payment (P) is $1,200/mo. Approximately $200 is applied to the principal and the remaining $1,000 goes to pay the interest on the loan (as the loan is repaid, this ratio will change). The amount of tax savings that will result from your allowed $1,000 deduction at the end of the tax year is equal to your tax rate times the interest paid (in reality, tax rates are incremental. For example, married filing jointly; 10% on the first $6,000; 15% on earned income from $6,001-$27,950; 27% on earned income from $27,951-$67,700; 30% on earned income from $67,701-$141,250; 35%; 38.6%; etc.)
For example, if you are in a 30% tax bracket, you would realize only a $300 savings in taxes from your allowed $1,000 deduction (for educational purposes, I use a flat 30% and not the incremental amount). In effect that $300 savings cost you $900 in payments to the bank (don't forget that you will also have to pay taxes on the $200 that is not interest which would equate to $60 in this example). Once your mortgage is paid, you will be able to keep the money you paid the bank resulting in an increase in cash flow into your budget of approximately $800. At this point you could even give the $1,000 you were paying in interest to a charitable organization and continue to get the $300 tax savings.
The chart below gives you a visual illustration of the example outlined above:
| Total Payment | Tax Rate | Interest Paid | Tax Savings |
| $1,200 | 30% | $1,000 | $300 |
The chart below shows the tax consequences as a result of not getting the tax savings as a result of the interest payment deductions:
| Income | Tax Rate | Taxes Paid | Net Gain |
| $1,200 | 30% | $360 | $840 |
The illustration above shows that while the tax savings that result from the allowed deduction of your mortgage interest is a good thing, it is not justification to keep the debt. You would realize an increase in cash flow into your budget if your mortgage loan was paid in full. Having said that, the mortgage loan should be one of the last debts that you focus on. The primary focus is always on consumer debts (services or items that go down in value or have been used or consumed that have been purchased using debt ).
The goal with a mortgage loan is to at least be able to pay it off before you reach the age of retirement or reduced earning capacity. But better yet, to pay it off in time to maximize your savings for retirement so as not to be dependant on relatives or welfare. The shorter the term of the loan the faster you will reach your goals. Your income level and HOUSE requirements (determined by your budget) are the variables that determine what an acceptable mortgage payment should be.
Below is a chart that will show you how you can dramatically change the length of your mortgage with a relatively small additional payment to your principle (all of the rates are computed at 7%).
| LOAN | TERM | PAYMENT | INCREASE | NEW TERM |
| $100,000 | 30 yrs | $665 | $50 | 24.75 yrs |
| $100,000 | 30 yrs | $665 | $100 | 20.6 yrs |
| $100,000 | 30 yrs | $665 | $150 | 18 yrs |
| $100,000 | 30 yrs | $665 | $200 | 16 yrs |
| $100,000 | 30 yrs | $665 | $250 | 14.5 yrs |
As a word of encouragement, anyone who has a mortgage that is within their means, is willing to apply the necessary discipline and live by a monthly budget can be TOTALLY debt free in 10 years!
One last comment about paying your mortgage off early. Some would argue that the additional dollars used to pay off your mortgage would be better used if invested at a higher interest rate than that of your existing mortgage rate. This always sounds good on paper but in reality there are several variables that are not always factored in. First, the rate that you pay on your mortgage is RISK FREE. This means that for every dollar that you pay on your mortgage debt, you are in effect guaranteed a rate of return equal to your loan rate. Risk is often an overlooked factor when considering an investment. There are also the tax consequences of capital gains to consider. Another small consideration is that when your mortgage debt is retired, your life insurance requirements can be reduced. And then there is freedom and peace of mind which in my opinion and has been my experience, far exceeds any potential financial considerations.
Before you pay someone to do something for you that you can do for yourself, just send your money to me and I'll do it for you. All of the bi-weekly payment plans charge a fee for their service. You can do the same thing for yourself just by making an additional principal payment to your mortgage either monthly or periodically throughout the year. The effect on the term of the mortgage is the same. Making a bi-weekly payment is approximately equal to making an additional payment once a year.
You should consider refinancing if you plan to stay in your home longer than the number of months required to break even on the cost required to refinance. The closing cost will be approximately 2-3 % of the loan amount. To calculate your break even point use the example below:
| Loan Amount | $100,000 |
| Current Loan Rate | 8 % |
| Current Principal and Interest Payment (P.I. only) | $733 |
| New Loan Rate | 7% |
| (Minus) the new Principal and Interest Payment | $665 |
| Equals your Monthly Savings | $68 |
| *Closing Cost divided by Savings = months to break even | 30.88 months |
* Assume a closing cost of $2,100 or 2% of the $100,000 loan amount.
The lower the new loan rate is the greater the savings that will be realized and the shorter the time until break even on the cost to refinance. In the above example, a one point reduction in the loan rate would require almost a three year commitment before breaking even.
If you are considering whether to refinance or not, you might want to look at the possibility of keeping the same payment and reducing the term. This will result in major savings as outlined in the examples given above.
Getting a credit card or some other form of consumer debt to "establish credit" is not necessary in order to qualify for a mortgage loan. Those without established credit ratings are only required to build 4 lines of credit in order to qualify for a mortgage loan with most lenders. Those lines of credit can be auto insurance, rent payments, phone bills, electric bills, gas bills, cable TV bills, cell phone bills, and the list goes on. Mortgage lenders are not even concerned how long you have been with your current employer.
FHA mortgage lenders can qualify you for a mortgage loan after completing 12 months in a Chapter 13 bankruptcy with a letter of recommendation from the bankruptcy trustee. For Chapter 7 bankruptcies, you must wait 2 years and have acceptable credit.
