How Much Can We Afford?
Lenders work with a few different factors to determine what loan amount they will approve. The most important factors are “ratios”, in which they look at the amount of monthly loan payment and the amount of your total monthly expenses verses your gross monthly income. For example, assuming you wanted to purchase a house for $500,000, and you have a gross monthly income of $8,333 ($100,000 annually), and $100,000 (20%) available for a down payment. Your monthly housing costs assuming a 30 year fixed rate loan with an interest rate of 5.75%, would be a loan payment of $2334 + property taxes of roughly $500 for a total of $2834. Your monthly housing payment would equal 34% of your gross monthly income. Assume from the example above that you also have a car payment of $300 monthly and minimum monthly credit card payments of $200. When adding that $500 to your monthly housing costs, your total monthly expenditures are $3334 or 40% of your gross monthly income. These parameters are in the acceptable range for many lenders, but each lender is different. Your credit score can also affect the ratios a particular lender is willing to accept. It can help to be aware of these factors and perhaps pay off some outstanding debts prior to applying for a loan if your ratios are too high for the loan amount you want. Additionally, FHA (Federal Housing Administration) loans have become much more popular due to their lower down payment requirements (as little as 3 1/2%), and their willingness to accept somewhat higher ratios than conventional lenders. You can see some different scenarios on affordability at RPM Mortgage’s Loan Calculator Page.
Down Payment Amount
20% is the minimum amount required in many cases for a conventional loan, although some lenders will still accept 10% or 15% down payment with PMI (Private Mortgage Insurance) added to your monthly payment each month. PMI rates can vary can vary depending a number of factors, including your credit score. Also, FHA loans, which require only 3 1/2% down payment have become very popular with people having limited funds for a down payment.
These government backed loans were utilized very little during the housing boom, as they had low income limits, higher cost to sellers, and low property value limits. That has all changed now, and FHA loans have become one of the most popular types of loans for new buyers. Higher loan limits, down payments as low as 3 1/2%, and low interest rates have made these loans some of the most attractive out there. FHA loans, however, do carry fairly steep costs for mortgage insurance. There is an initial mortgage insurance premium of 1% of the loan amount charged at the inception of the loan, and then an additional charge to maintain the mortgage insurance in each monthly payment equal to an annual fee of 1.1% of the loan amount. On a $500,000 loan, this amounts to $5000 upfront, and $458 added to each monthly payment. Mortgage insurance can only be removed by paying down the loan balance to 80% of the property value or by refinancing later with another lender that won’t charge for mortgage insurance.
Interest rates can vary based on a number of factors. There are a number of sources online where you can track the average rate for a 30 year mortgage daily, such as www.bankrate.com. The interest rate you’ll be quoted by a lender when they actually review your application will depend upon your credit score, down payment, ratios and loan amount. Currently, the “conforming” loan limit is $417,000, meaning that any loans under this amount for a first deed of trust will get the lowest possible rate. Higher loan amounts, ranging from $417,001 to $650,000 are considered to be “Jumbo” loans, and will generally have interest rates somewhat higher than conforming loans. Any loan amount above $650,000 is considered “Super Jumbo” and will also have slightly higher rates. For 2009, Fannie Mae and Freddie Mac have designated Contra Costa County as a “high-cost” area, and thus have raised conforming loan limits for this year to $729,950. Loans above the conforming limit of $417,000, but below the “high limit” conforming amount of $729,950 are known as “Jumbo conforming” and tend to carry slightly higher rates than regular conforming loans. These limits are reviewed and may change annually.
Points are simply an upfront fee paid to the mortgage lender for originating the loan. 1 point = 1% of the loan amount, so if you see a loan advertised at 5.5% with 1 point, and you are in search of a mortgage for $400,000, you can expect a $4000 charge to be paid to the lender upfront at close of escrow. Points are also typically interchangeable with interest rates, meaning that you can obtain a lower interest rate by paying more points, and may be offered a higher interest rate with no points. If you plan to stay in the home you’re purchasing for a long time, it may make sense to consider paying more upfront points to reduce your interest rate.
Prior to applying for a mortgage, you should check your credit report and credit score at all three major credit reporting agencies, Experian, Equifax and TransUnion. While you can obtain a free annual credit report for all 3 agencies at www.annualcreditreport.com, unfortunately, you’ll likely need to pay to see your credit score. Each lender will have different criteria for the minimum credit score required to receive the best interest rate. When reviewing your credit reports, make sure that you not only check for any inaccurate information in regards to late payments or collections, but also make sure that there are no accounts still showing balances that have actually been paid, as this can affect not only your credit score, but ratios that the lender will use to qualify you for the loan amount you request. If you do find inaccurate information, you’ll need to dispute it with each credit bureau separately. Also, if you’re planning on applying for a mortgage in the upcoming year, try and limit the number of times you apply for credit elsewhere, as the credit bureaus view any inquiry or credit report run on you as negative information they will use to lower your credit score. (Requesting a report yourself does not count as an inquiry)
Adjustable or Fixed Rate Mortgage
At the height of the housing bubble, adjustable rate mortgages were the prevailing loans seen in the marketplace. They start at a low “teaser” rate, and then adjust at the end of a particular term, usually 1, 3, or 5 years into the loan, at which point the interest rate, and the monthly payment can change dramatically based on the current market conditions at the time. Fixed rate loans, by contrast, remain consistent in interest rate and payment amount throughout the term of the loan. Adjustable rate loans should be at a lower interest rate than a fixed rate loan, since they have a higher risk factor to the borrower.
One of the biggest problems of the housing boom was the proliferation of adjustable rate loans. While they can seem a good deal up front, the possibility of a large increase in interest rate in the future makes these loans extremely risky. You can also see substantial increases in your monthly payment in the future. Be sure you understand all the terms of any home loan, and don’t be taken in by ads for extremely low interest rates and monthly payments. It is these types of loans that have led to the housing market problems we see today!
Private Mortgage Insurance
Private mortgage insurance or PMI is required by most conventional lenders when there is a down payment of less than 20% of the purchase price. PMI rates vary between lenders. One important thing to realize is that PMI protects the lender if you default on the loan, but despite the fact that you pay the premiums each month, PMI in no way protects you! Once a loan is established with PMI, it is very hard to get the lender to agree to drop it. You will likely need to show that your current equity in the home exceeds 20% or 25%, or you can refinance into a new loan without PMI. As mentioned above, FHA loans have become much more popular with their lower down payment FHA loans charge an upfront MI fee of 1% of the loan amount, and monthly PMI payments of 1.15% of the loan amount.
Property taxes in California are set at 1% of the property’s value annually by Proposition 13. In addition, local jurisdictions will have additional fees added to your property tax bill for items such as local parks & schools, sewer maintenance, etc. While the overall property tax rate can vary by city or county, we typically use a rate of 1.2% of the total value of the property annually as an estimate. For example, a home purchased for $500,000 multiplied by 1.2% would be $6000 annually, or roughly $500 monthly. Property taxes are due in two equal payments, due by December 10 and April 10 each year. Your lender will also offer you the opportunity to have them collect the amount for your taxes and insurance on a monthly basis with your loan payment. In that case, they will also collect “impounds” from you at the closing of the sale usually equal to the amount of 6 months of property tax payments to fund your “escrow” account they will open for you in order to make sure they have enough funds to pay the taxes when they become due.
Another option is asking the seller to finance part of the purchase price. If the seller has substantial equity in the property, and if it is an unusual or difficult to sell property, a seller may agree to finance a part or all of the purchase themselves. This would be treated like any other mortgage loan, and the interest rate and terms can be negotiated directly with the seller.