One of the most common questions I hear in the mortgage business is, “How much house can I afford?” It should be a relatively easy question to answer, and I suppose in the old days it was. Back when loan programs were simple fixed rates and your local bank knew your finances, you could easily figure out the payment that would make sense for the long haul. With today’s complex array of loan programs and additional factors, such as tax deductibility, the question of affordability requires a little more investigation and planning. It wasn’t so long ago that the banks could be your guide to figuring out how much house you could afford. Today, banks are focused on selling loans that meet Wall Street criteria. By using computers to analyze your credit history and payment patterns, they now determine risk on a percentage basis. Often, this results in qualifying you for a payment that may be much more or less than you are comfortable paying. While the banking approach may not assure you of being able to happily make the payment on your log home each and every month, looking at it will give you a basis from which to assess your own comfort level, not to mention ensure you are prepared when you are ready to apply for your loan.
Loan to Value (LTV)
Since mortgage lenders secure their loans against your real estate, the ratio of how much they will lend you relative to value is their primary consideration when establishing the right loan amount for you. Regardless of your income, credit or any other personal factor, the lender will establish a maximum percentage it is willing to lend against the value of the property. This percentage can vary, depending upon the size of the loan and other risk factors, such as large acreage and whether you intend to occupy the home as a primary or secondary residence. Lenders will typically lend up to 80 percent of value so that their risk is mitigated should they have to take the property back from you and resell it. For those occasions when the lender allows more than 80 percent, it generally looks to share the risk, either through private mortgage insurance or, often, with a second lender securing a second mortgage at a higher interest rate to offset the risk.
Lenders look for two things when examining your credit report. First, they check to see if you are credit worthy. In their perfect world, you have paid all of your bills on time without ever going into bankruptcy or foreclosure. If you did have any sort of late payments or collection accounts, they occurred well more than two years ago. The banks also like people who don’t apply for a lot of credit and don’t carry high balances on their credit cards. If you fit this profile, you have likely been rewarded with a credit score above 700. This is your ticket to a higher LTV and more flexibility from the lender when considering other aspects of your loan. While this score may accurately reflect your willingness to pay your bills on time and manage your credit, it doesn’t automatically have an impact on your ability to pay out more money each and every month. After establishing your creditworthiness, the lender will use your credit report to total up your monthly payments aside from your housing expense.
Over the last 15 years, lenders have made income less of a focus for qualifying loans than other criteria, such as LTV and credit. After reviewing historical data going back to the 1950s, the lending community realized that people with good credit and strong equity tend to make their payments on time in order to stay that way. Many lending institutions recognized that reducing the amount of taxable income people report is a national pastime and wanted to lend money to these people who were having difficulty producing tax returns worthy of home financing. To accomplish this they created the no-income qualifier (NIQ). There are several types of NIQ. Some require you to state an income that more accurately reflects the money you take in before taxes. This is helpful for self-employed or commission types. Others allow you to simply state your assets as well. Since no one verifies the information, many people are optimistic regarding the stated amounts. For excellent credit with a low LTV, some banks may even offer a loan that does not require you to state an income at all. An appraisal, credit report and signature are all that are required.
Often overlooked by consumers as an important lending issue is the amount of money they have readily available. Since many Americans today have most of their nest egg tied up in real-estate equity, they mistakenly believe they look good on paper to the lenders. In actuality, equity plays a positive role only in the LTV issue discussed earlier. Even if you have ready access to your equity through a home-equity line of credit (HELOC), the lender does not consider those funds to be at all liquid. The lender is interested in your ability to save. It wants to see liquid assets, meaning cash, stocks, bonds and 401k funds that are in line with the income you are showing or perhaps simply claiming. The lender wants to feel comfortable that you can manage to make at least a few payments should you experience a loss of work or some other financial catastrophe. For most loans, three to six months times your payments is a minimum acceptable amount to make a lender comfortable.
Finding Your Comfort Zone
Just because you fit all the guidelines to make the lenders happy doesn’t necessarily mean you can afford the home. Other factors need to be considered including your tax situation and your lifestyle. One way to assess how much payment you can manage is to calculate a rough cash-flow analysis. First, you need to calculate your monthly income after taxes. Start by including everything: salary, commissions, interest and dividends. If your eBay hobby is generating extra cash, make sure you include that as well. We will call the total gross monthly income, or GMI. Next, subtract any tax deductions, such as your monthly mortgage interest and property taxes, as well as any deferred retirement contributions. The remaining total is your taxable monthly income, or TMI. Next, contact your accountant or tax preparer and find out what your tax and Social Security would be on your TMI. This is your monthly income tax, or MIT. Now we can begin the cash-flow analysis. Start again with your GMI and subtract all expenses, including the MIT and house payment. Remember to include insurance, utilities, car payments, day care, 401k contribution, etc. After you have subtracted all of your expenses, the remainder is your net disposable income. This is the amount of money you have left to save and live on after making all of your payments. Kevin Daum is the author of the comprehensive, custom home guide Building Your Own Home For Dummies and What the Banks Won’t Tell You: How to Get the Most Out of Your Mortgage. As CEO of Stratford Financial, he has financed hundreds of dream homes.