As a new home buyer, it is essential to have a realistic idea of how much home you can afford before entering a negotiatons on an offer to purchase. Just like car buying, or any other major investment, it is important to know what comfortable home value fits your budget based on various factors. Most mortgage lenders utilize a similar set of ratios comparing income and debt to help evaluate home buyers for risk and ability to pay a mortgage after closing on a home. Of course, this is only one portion of the overall financial picture, other considerations will be to check a FICO credit score (the best rates are typically to individuals who achieve a score of 750 or higher), as well as length of time employed, type of career stability, history of good debt management, paying bills on time consistently, and current financial obligations (credit card debit, child support, student loans, auto loans, alimony, business expenses, etc.)
How Mortgage Lenders Evaluate Individual Home Buyer Risk For Loan Pre-Qualification
The most common form of evaluation utilizes two ratios (called the 28/36 rule). The basic concept involves comparing GMI (gross monthly income) to total monthly home expenses and home expenses plus over recurring debt. Conventional/conforming loans are more stringent in their regulations (less backing by secondary mortgage agencies such as Fannie Mae and Freddie Mac), and tend to stick to the 28/36 rules. The more common FHA loans often are a little more lenient, and can increase to 29/41% IF the individual also has a good financial appearance otherwise.
RATIO 1: Gross Monthly Income VS. Total Monthly Home Debt
STEP 1: A home buyer (individual or family) can take all sources of income and divide into 12 monthly values BEFORE taxes (called GMI or gross monthly income). This must include working income, rental income, dividends, pensions, and other reliable income. These should be provable repetitive sources of income, as lenders will usually require pay stubs or other representation of these sources. Expected commissions or other irregular pay will be more difficult to prove, but can still be proven by prior quarterly payments or annual bonuses on W-2's and prior tax documents.
STEP 2: Find the total anticipated monthly home expenses (monthly mortgage for principal and interest, as well as total annual property taxes and hazard home insurance divided by 12 months). This is often called the PITI when a home buyer will utilize escrow accounts to pay insurance/taxes regularly. Take this amount total to calculate the first ratio that lenders evaluate.
STEP 3: DIVIDE Total Monthly Home Debt BY GMI
The goal is for the ratio to be at 28% or below, to avoid the mistake of higher obligations related to being "house poor" for the buyer and greater risk for the mortgage lender.
RATIO 2: Gross Monthly Income VS. Total Recurring Monthly Debt (All other plus Home in Ratio 1)
STEP 1: Calculate the same GMI used in Ratio 1 (gross monthly income BEFORE taxes)
STEP 2: List all recurring debts that last longer than 6 months that require minimum payments to avoid penalties. This could include but not be limited to: credit cards (minimum monthly payment on REVOLVING debt not paid off every month), car payments (lease or purchase with more than 6 months remaining), alimony, child support, student loans, business investments, etc.). Items that are optional and can be canceled at any time do not need to be included unless the buyer wants to be conservative in their personal budgeting to mimic real life when in the home (i.e. gym memberships, college plans/529, Roth IRA retirement contributions after-tax, other optional memberships and expenses).
STEP 3: Add all items in Step 2 to the total monthly home expenses calculated in STEP 2 of RATIO 1 for the total recurring monthly debt.
STEP 4: Divide the Total monthly recurring debt by GMI (gross monthly income). This ratio should be less than 36% for conventional/conforming loans, or can possibly increase up to 41% with more lenient and popular FHA loans.
Available Down Payment, Credit Scores, Length Of Time And Other Considerations for Buying A House
As a potential buyer, other considerations to determine the best financial planning includes concepts such as how long the buyer expects to be in the property (if less than 2-3 years, perhaps renting may be a more financially savvy option due to the expenses of real estate fees, closing costs, maintenance, landscaping). If the owner expects to have a large increase in salary or hours at work in the next few years, perhaps an adjustable rate mortgage may allow flexibility (but proceed with caution, this was a common mistake in previous years that increased a home buyer's risk into buying more home than they could really afford when the readjustment did occur after the initial ARM rates ended). The opposite is also true, if one person in a household is considering to decrease hours or stop working, perhaps for starting a family, a more conservative approach makes better sense to pre-qualify on the future expected decreased income level, again to be more realistic and conservative and avoid strain.
Also, a buyer needs to consider the amount of down payment available, as most FHA loans will require 3 1/2 percent to 5%, and conventional loans may need up to 10% depending on the approval process. Closing costs need to be added to the down payment to create the total needed monies at closing (typically 4-5% of the purchase price is a realistic value, although many buyers may consider negotiating for a portion of the buyer closing costs to be paid by the seller or builder when placing an offer to reduce some of these expenses). The loan value must be large enough to cover the remaining home expense after closing costs and down payment have been calculated into the situation. Also, the bank will usually not offer a loan greater than the purchase price or appraisal, which is usually required prior to closing.
The best advice is to begin working on building good credit scores immediately, by paying all bills on time (the MOST important factor that impacts the majority of a credit score), reducing credit card debt/revolving debt, by NOT opening new credit lines (i.e. credit cards) to reduce a credit score, and by pulling a free credit report from each of the three major credit score organizations a year (such as at myFICO.com). If any errors are present, contact the agency immediately to correct, and to protect against identity theft if an unfamiliar address is listed or credit lines opened that are not authorized. A frank discussion with a mortgage broker/lender will be very helpful to decide the types of loan products best for the individual situation, and help decide on a realistic home price range BEFORE looking at homes. By being realistic, in the long run, a home buyer will be much happier and satisfied throughout the purchase process. By having a sound financial plan, a more specific range of homes can be showed by an exclusive buyer agent protecting a buyer's interests and bargaining power, who will keep all details related to their buying power confidential throughout the process. The agent can also perform a comparative market analysis based on the buyer's budget and pre-qualification range to match the best homes to their financial and family needs.
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