So, you’ve decided that home ownership is right for you. Now you need to determine if you are financially ready to buy a house. In this Step, you will find how much house you can afford and the maximum home price that you should be considering.
To avoid any future surprises, you can do some financial exercises to see where you stand. They include calculating your net worth, determining your current monthly expenses and what your current monthly debt payments are.
Knowing your debt to income ratio is important because you will need this information when you discuss a mortgage with your mortgage professional. Your debt to income ratio is the amount left over once you’ve subtracted your total liabilities from your total assets. It will also give you a snapshot of your current financial situation and show you how much you can afford to put as a down payment.
How Much Can You Afford?
Now that you have a clear picture of your current financial situation, it’s time to find out what you can afford in monthly housing costs. Lenders follow two simple affordability rules to determine how much you can pay.
The first affordability rule is that your monthly housing costs shouldn’t be more than 32% of your gross household monthly income. Housing costs include monthly mortgage principal and interest, taxes and insurance— known as P.I.T.I. for short. For a condominium, P.I.T.I. also includes the monthly condominium fees.
Lenders add up these housing costs to determine what percentage they are of your gross monthly income. This figure is known as your Gross Debt Service (GDS) ratio. Remember, it must be 32% or less of your gross household monthly income.
The second affordability rule is that your entire monthly debt load shouldn’t be more than 50% of your gross monthly income. This includes housing costs and other debts, such as car loans and credit card payments. Lenders add up these debts to determine what percentage they are of your gross household monthly income. This figure is your Total Debt Service (DTI) ratio
Get a Mortgage Pre-Approval
Once you’ve made the necessary calculations and feel that you are ready to obtain a mortgage, it’s a good idea to select a lender to get pre-approved. This means that the lender will look at your finances to establish the amount of mortgage you can afford. At that time, the lender will give you a written loan status report signifying preliminary loan approval.
Some buyers may not wish to pursue a mortgage pre-approval until they have found the home they want to buy. However, having a pre-approved mortgage amount makes the search for your new home much easier and less time-consuming because you have a good price range in mind.
Some of the things you will need to have with you the first time you meet with a lender are:
* Your personal information, including identification such as your driver’s license
* Details on your job, including confirmation of salary in the form of a letter from your employer
* Your sources of income
* Information and details on all bank accounts, loans and other debts
* Proof of financial assets
* Source and amount of down payment and deposit
* Proof of source of funds for the closing costs (these are usually between 1.5% and 4% of the purchase price)
2. What You Need to Know about Your Credit Rating and Report
Your credit rating is one of the most important pieces of financial information that your lender can obtain about you. Your credit report details each loan that you have, your payment history, employment record, and any other debt you may have. It will also include any outstanding judgements or liens against you. Your credit is considered crucial by lenders and will ultimately effect if you can get approved for a loan and at what cost.
While you should check your credit reports on an annual basis to verify their accuracy, you should at least check it prior to applying for funds to purchase a home. You can obtain a copy of your credit report from one of the three major credit bureaus, Experian, Equifax, or Trans Union along with your credit rating. A credit rating above 620 is considered good but ideally you would like to be over 720. The higher the score, the more likely it is that you will receive the requested funds and favorable interest rates.
A pre-approved mortgage certificate or LSR is not a guarantee of being approved for the mortgage loan. Even if you have a pre-approval, you must still meet your lender during the conditional offer period to get a final mortgage approval. To ensure that the process goes smoothly, make sure you bring:
* A copy of the property listing; and
* A copy of the signed Offer to Purchase
Your lender will update/verify your financial information, and put together the information required to complete the mortgage application. Your lender may require an appraisal and/or a survey. Title insurance may also be required. Your lender will also inform you about the various types of mortgages, terms, interest rates, amortization periods and payment schedules available.
Depending on your down payment, you may have a conventional or high-ratio mortgage.
A conventional mortgage is a mortgage loan that does not exceed 80% of the lending value of the property. The lending value is typically the lesser of the property’s purchase price and market value.
If you contribute less than 20% of the home price as a down payment you will typically need a high-ratio mortgage. This type of mortgage usually requires mortgage loan insurance. Your lender may add the mortgage insurance premium to your mortgage or ask you to pay it in full upon closing.
Fixed, Variable or Adjustable Interest Rate
Mortgage interest rates are either fixed, variable or adjustable. A fixed rate is a locked-in rate that will not increase for the term of the mortgage. A variable rate fluctuates based on market conditions while the mortgage payment remains unchanged. With an adjustable rate, both the interest rate and the mortgage payment vary based on market conditions.
Your lender will also tell you about the term options for the mortgage. This is the length of time that the agreed-upon mortgage contract conditions, including interest rate, will be fixed. It can vary from six months to 10 years. Choosing a longer term (for example, five years) gives you the chance to plan ahead and protects you from interest rate increases while you adjust to home ownership. Weigh your options carefully and don’t be afraid to ask your lender to work out the differences between a one, two, five-year or longer terms.
This is the amount of time over which the entire debt will be repaid. Many mortgages are amortized over 25 years, but longer periods are available. The longer the amortization, the lower your scheduled mortgage payments, but the more interest you pay in the long run.
A mortgage loan is often repaid in regular payments, either monthly, biweekly or weekly. Payment schedules that are more frequent can save some interest costs by reducing the outstanding principal balance more quickly than with monthly payments. The more payments you make in a year, the lower the overall interest you have to pay on your mortgage.
Keep in mind that mortgages may have important payment features that can save you money and let you be mortgage-free sooner.
Once the Offer is Accepted