Bankers and mortgage lenders follow two guidelines to help them determine how much loan you can afford. First, they follow a guideline known as the Payment to Income Ratio. Secondly, they look at what is called your Debt to Income Ratio. Both are critical components to a loan and something you should be very familiar with as a potential borrower. We’ll explain both.
Payment to Income Ratio
Your Payment to Income Ratio compares your income or total household income, to the amount of mortgage payment you’re considering. Lenders will usually loan up to 28% of your total household income. Here’s how they calculate the payment part of the formula.
- The lender will take the mortgage payment, principal + interest, and add it to the Property Taxes and Insurance. They normally refer to this using the term “PITI” (principal, interest, taxes, and insurance).
Debt to Income Ratio
Next they look at what’s called the Debt to Income Ratio. They will compare your total debt to your ability to make current payments with your new home loan. They consider debt to be any of the following; car payment, credit card debt and payments, IRS liens or payments due, and any other payments and debts you may have.
Now each mortgage company sets different limits on your Debt to Income Ratio, which is why you need to find a motivated lender. You will want to find a mortgage company who will do more than just the bare minimum and get you into a program that is designed for low credit rating and high interest rates.
The key is to do your homework. Spend two or three days finding a loan that can save you $40,000 to $150,00 over its term. Time is money; so spend your time looking for the right mortgage company for your needs.
Save a bundle when financing
When it comes to financing, each individual case is different. Your own personal circumstances will have an impact on how much home you can afford. There is not a general rule to follow when it comes down to financing. There are many factors that can impact your overall financial statement.
Generally, people put down 20% or more as equity. Putting down more cash on your home than what is required could result in missing out on a better return investment. Here are a couple of quick tips to estimate what the actual annual return on investment will be from the money you put down on your home.
- Find out how much the homes in your area have appreciated over the past five years.
- Take your total cost of your home, multiply that value by what percentage those homes have appreciated in the past fives years.
- Then divide that amount of increase in your home by the total amount of down payment you put into the home.
Many bankers will appreciate you putting more money into your home, mainly because it lowers the risk of getting the bankers money out if you for some reason default. However, finding an alternate investment that will pay greater interest on your equity, will make it easier for you to put less into your home, making your overall payment a little lower.
The table below will illustrate the impact the interest rates can have on your overall finances.
|Interest Rate 8%
This table shows the interest you would pay over the term of a 30-year, $150,000 loan at 8%, 7%, and 6%.
Remember not only to look at the interest rate. The next table will show you the impact on your overall finances when modifying the term of your loan.
|Monthly Pmt. $998
|Interest Paid $209,280
Again, this table uses the example of a $150,000 loan at 7% interest but at a term of 30, 15, and 10 years.
You want to estimate the maximum amount of payment you can afford and simply adjust the term and interest rate of your loan to minimize the amount of total interest you will pay. Normally, when you do this your banker may cut in and try to advise you that the interest you pay is Tax Deductible. You want to keep this in mind, if you’re in the 28% tax bracket, for every dollar of interest you pay you will only save 28 cents.
What Are Points?
Another factor to consider is the amount of POINTS your lender will charge you to initiate your loan. If many options are being presented to you, you’ll want to sort out the financial consequences so you don’t end up losing money. The one factor that will help determine which loan offer is better than the other is how long you keep the loan.
You’ll want to consider how long you are going to live in your new home. On average homeowners spend about 5.5 years in their home before selling. As an example, lets say that you plan to live in your home for 5 years, here’s a way to help you determine which loan offer is better.
- Take the difference in your monthly payments of each loan.
- Multiply that amount by 12 months to get the annual amount of difference.
- Divide that amount into the amount of points you’ll pay to determine the number of years at which you end up recovering the points you paid up front.
If the number of years is less than your anticipated time in your home, you are better off paying the points and getting the lower rate. If it’s higher than you plan to spend in the home, opt for the lower points.
The result is simple, if you stay in your home for 5 years, you will not recoup the points you paid up front with the savings in a lower interest rate. Recoup time for a lower interest rate is normally about 6 years and 2 months, and that is to break even. IF, however you plan to stay the 6 years and 2 months or longer than the overall savings in interest rate will exceed the amount you paid in points, and that is not considering the time value of money. Ultimately, it is very important for you to shop for the best rates, terms, and points.
Keeping It Real,
The Cloninger Properties Team