How Much House Can I Afford? (Part 1 of 2)

As with most decisions when buying a house, figuring out how much house you can afford is half financial and half psychological.  My goal as a real estate agent is to see you deliriously happy after buying a house and how happy you are after your purchase depends on how well you balance the two.  This is part one of a two part article on how much house you can afford.

Smiley Face

Part 1: The Financial Half

How much of a house you can afford financially boils down to convincing your lender to let you borrow enough money to purchase the house.  Most lenders will lend you what you need if they can answer "yes" to three basic questions:

1.  Can you pay back the mortgage?

2.  Will you pay back the mortgage?

3.  Do you value paying back the mortgage?

"Can you pay back the mortgage?"

Lenders answer this question using your income compared to how much you owe others.  This comparison is called your debt-to-income ratio; it is your income before taxes divided by your liabilities. 

So, for example, if you owe $1,000 per month and earn $5,000 per month, your debt-to-income ratio is 20%.  If you have no debt, your debt-to-income ratio is zero.

Lenders have a general rule that your debt-to-income ratio should not exceed more than 36% of your income.  The debt they use includes the mortgage you are applying for, your car loan, student loans, credit card balances, and any money you owe other institutions.

There are a number of debt-to-income calculators on the Internet.  If you are looking to purchase a house, a good way to increase your chances of getting a quality mortgage is to pay off debt (without canceling or closing your lines of credit).

Most lenders use another rule as well: that no more than around 40%, sometimes even 50%, of your gross income, how much you make before taxes, should go towards paying for your house and the expenses associated with it.  This combination of principal, interest, taxes and insurance is known as PITI. 

I strongly believe, though, that your comfort level is more important than the amount the lender will let you borrow.  After all, their incentive is to earn interest on as large a loan as possible.  My goal is your delirious happiness. 

If we run the numbers and you believe your PITI exceeds what you're comfortable spending each month, you have a few options to play with: lowering your mortgage payments, increasing your income, finding a less expensive house, or waiting on your home purchase until you can make a larger down payment.  

"Will you pay back the mortgage?"

Lenders use your credit score to decide the answer to whether you will pay back the mortgage.  While a number of companies have devised ways to calculate your credit rating, only one matters: your FICO score.

When applying for a mortgage, your FICO score is the primary factor in whether you qualify and how much you will pay in fees and interest. It's a number between 300 and 850 and is meant to be a quick illustration of how likely you are to pay your bills on time, if at all.

In general, if your FICO score is above 720, you will have flexibility in what loans you can ask for and may qualify for a discount, and if your score is above 800, you have considerable bargaining power. But if your FICO score is 680 or below, mortgages will be more expensive and much more difficult to get.

"Do you value paying back your mortgage?"

Lenders infer how much you value paying back your mortgage by how much of a down payment you provide.  Down payments are paid as cash upfront.  If you stop paying your mortgage, you "lose" your down payment when the lender forecloses on the house.  How much you should put down depends on your situation.

Your lender will usually allow you to make a smaller than 20% down payment, either through a "piggy-back" loan or PMI, which can give you more financial flexibility. 

If you put down 20% or more of the house's purchase price as a down payment, they will generally start you off with their lower mortgage rates.  If you don't put anything down, they will generally impose additional fees.

Bottom line: Lenders need to answer "yes" to all three questions before you can get a mortgage.

Your #1 Defense Against Getting Ripped-Off on a Mortgage

Getting a mortgage and buying a house involves around 300 sheets of paper.  And many people are intimidated by the monumental stack of formerly living trees or the terms they don't know printed on them.  But with only a few key concepts, you can usually protect yourself from getting very ripped-off.

When looking for a mortgage, most people know to look at the rate, terms, amortization, and monthly payments.  While these are obviously very important characteristics of a loan, the key item to look out for --- one that careful people good at math miss --- is a prepayment penalty. 

A prepayment penalty is an extra amount of money you need to give the lender if you decide to pay much more of your mortgage debt than is actually due.  It's like having to pay your credit card company if you want to pay off your balance in full. 

Prepayment Penalty Impact

Without a prepayment penalty, you can usually erase mistakes you made in getting your mortgage through refinancing: if, for example you locked into too high a rate or need to pull equity out of your house for an unexpected reason, you can get rid of the old mortgage by refinancing to a new one and paying whatever closing costs are associated with it.

With a prepayment penalty, you'll have less flexibility because the refinancing will effectively be more expensive and you might be charged if you sell your house.  With investments as large and life-changing as real estate, flexibility in the face of unforeseen circumstances is often very valuable.

Why Do People Agree to Them?

People often agree to these clauses because the lender gives them a better rate, more favorable payment terms, or a loan they might not have otherwise qualified for. 

Unfortunately, because the penalty is not always obvious or properly disclosed, many people agree to them without knowing that they did.

Lenders Love Prepayment Penalties

The lender benefits because they effectively lock you into a certain payment schedule for a certain number of years and can penalize you for trying to leave them by refinancing. 

Though penalties may also be triggered by selling your house, lenders can waive them under certain circumstances. 

Freddie Mac's Don't Borrow Trouble series provides more detail about pre-payment penalties.

Bottom line: Look out for any prepayment penalties in your mortgage and understand very carefully what you get in return for them before being locked into one.

Empowering Yourself Through Your Credit Rating

Your FICO score is the number makes-or-breaks your ability to buy a house and determines whether you get the best rates or get charged enormous fees. You can directly affect the strength of your credit and, in turn, how much your dream house really costs you.

FICO Score Breakdown

When applying for a mortgage, your credit rating is the primary factor in whether you qualify and how much you will pay in fees and interest. Your credit rating can be boiled down to one number between 300 and 850: your FICO score. It's meant to be a quick illustration of how likely you are to pay your bills on time, if at all.

In general, if your FICO score is above 720, you will have flexibility in what loans you can ask for and may qualify for a discount, and if your score is above 800, you have considerable bargaining power.

But if your FICO score is 680 or below, mortgages will be more expensive and much more difficult to get. The chart above illustrates what factors get taken into account when determining your score.

Helping Your Credit Rating

• Have and use at least one credit card
• Only sparingly apply for loans, credit cards, or new lines of credit
• Pay your bills on time
• Reduce your debt and outstanding loan amounts
• Pay your credit card bills in full each month

One key point about your FICO score is that not having a credit history is almost as bad as having a bad one, so building evidence that you're a person who pays bills on time is important, but there's an additional nuance.

Your score is actually based on your debt ratio: how much credit you've used compared to how much you have.

Clearly your FICO score isn't going to be strong if you've maxed out all your credit cards and have car loans, student loans, and that zero percent financing deal hovering on your credit report. But it'll also be weak if you have a small amount of available credit and are using a large portion of it.

Hurting Your Credit Rating

• Paying bills late, missing payments, or bankruptcy
• Applying for credit haphazardly or too frequently
• Having too many credit checks run against you
• Closing credit card accounts right before you apply for a loan
• A major purchase on a credit card before you apply for a loan

Some of these points are obvious, but it may seem counterintuitive but closing credit card accounts before applying for a mortgage may hurt your credit rating as much as making a major purchase. It all goes back to your debt ratio and how much of your available credit you're using.

You want a balance between having a reasonable amount of available credit and not using too much of it.

And remember, while most actions don't change your credit score significantly, people whose scores hover around 720 need to be very careful to ensure it stays above any cutoffs pre-determined by your lender.  This will help your loan close and may help you get a better rate.

The Thought Process

FairIssac, the creator of the FICO score, has articles on what goes into your FICO score and how to improve it, but they only pay cursory attention to how mistakes are made.

Even in a computerized world, a great deal of financial information is transfered from one handwritten sheet of paper to another before it is keyed into a computer, which we know isn't perfect either.

The challenge is what to do if you believe there is a mistake causing your credit score to be lower than it should be. Knowing your credit information beforehand will give you leverage, or at least knowledge, when speaking with your lender.

You should empower yourself by getting a copy of your credit report beforehand, and if you suspect there is an error, call each of the appropriate credit bureaus, Equifax, Experian and Trans Union to rectify the problem.

Bankrate.com offers a helpful article on fixing an inaccurate credit report, plus, if you are in a hurry to make a house purchase, you can request a rapid re-score by the credit bureaus for a fee.

If you're sure you're going to buy a house, you should get not only your credit report but your FICO score as well. The major credit bureaus will sell you your "credit score" but unless it is your FICO score, it won't be relevant for your mortgage application.

Bottom line: you can secure a less-expensive mortgage more quickly by paying all your bills in full and not making any major financial changes during the mortgage process.

Opt-Out of Pre-Approved Credit Card Offers

Did you know you can opt-out of receiving those pre-approved credit card offers just like you can put yourself on the "Do Not Call" list for telemarketers?

There's good reason to do this.  Besides the fact that they're annoying, these pre-approved offers also put you at risk for identity theft. 

In fact, MSNBC posed the question, "What if a desperate identity thief digging through your trash found a credit card application ripped into little pieces, taped it back together, filled it out and mailed it in?"

"Would he get the credit card?"  The answer is one of those "You've got to be kidding me?!" moments.

So how do you opt-out of these pre-approved credit card lists, help protect your credit (especially if you're thinking about getting a mortgage), and get less junk mail in the process?

Removing Yourself

You can remove yourself from pre-approved lists for 5 years by opting-out online at OptOutPrescreen.com, the official site created by Equifax, Experian, Innovis, and Trans Union.  They also have instructions on removing yourself permanently in writing.

(And, in case you're wondering why they'd do this, they have to: it's the law.)

Beware of Scammers

Note that besides the web site and toll-free number 1-888-5OPT-OUT (1-888-567-8688) there aren't any other ways to remove yourself from the list, so don't give anyone else your information. 

You'll have to give the OptOutPrescreen.com web site or the folks on the toll-free your social security number and address because that's how they track you, your credit, and whether you get those mailings or not.

For the Determined

Still, some people receive offers even after opting out because some companies just fail to check the list.  The FTC provides additional contact information on Where to Go to "Just Say No" to these offers and even gives you a short sample letter you can send to credit bureaus.  They also provide information on reporting scams and tips for victims of identity theft.

And while you may never be able to eliminate all your junk mail, you can reduce it significantly and help protect your credit at the same time.

Ask Your Accountant: 2006 PMI Deduction

A basic benefit of buying a house is being able to deduct the interest you pay on mortgages from your income tax.  This benefit not only applies to your primary mortgage but also to "piggy-back" loans like your home equity line of credit (HELOC) if you put less than 20% down.

In the article, How Much Should You Allocate as a Down Payment?, I also talked about another way of putting less than 20% down.  (Again, putting a larger down payment on your house decreases your risk and may lower your interest rates and fees so there is a trade-off.)

This involved taking a greater mortgage from your lender and paying for private mortgage insurance (PMI).  The big disadvantage to PMI was that you couldn't deduct it like you could mortgage or HELOC interest.

Mortgage News Daily reports that, at the behest of happy private mortgage insurance lobbyists everywhere, the exiting Congress may have fixed all that...

Be sure to ask your accountant about any impact this potential change will have on your finances.  A larger deduction could reduce the amount of tax you have to pay.

The article states as of this writing:

"The Tax Relief and Health Care Act of 2006 was, by media accounts, passed by both the House and the Senate but has not yet been signed by President Bush.

Beyond that, even The Congressional Record as of Dec. 12 could not provide definitive information as to the final form of the bill as it was passed but all indications are that the PMI amendment was included.

Basically this means that those homeowners who put down less than 20 percent of the purchase price in securing a mortgage can now deduct the cost of the private mortgage insurance (PMI) they were required to purchase to protect their mortgage lender in the event of default. This amount can now be treated as mortgage interest by itemizers when filing Schedule A of the federal tax return."

How Much Should You Allocate as a Down Payment?

A long time ago, people put 20% of the purchase price as a down payment when buying a home.  You would pay this 20% upfront as a "cash" down payment through a cashiers check or by wiring money to the seller, and get a mortgage to pay them the remaining 80% of the price of the house. 

These days, very few people expect the optimal 20% down payment.  As a borrower, you have  choices that provide you greater financial flexibility, or more stability at a higher upfront cost.

Loan-to-Value (LTV) Ratio 

Lenders like larger down payments because it reduces their risk.  Putting more of your money into a deal is a sign that you are committed: you as a borrower are less likely to cut and run because you have put up a significant amount of cash upfront to buy the house.  You'd lose that investment along with the house if you ran.

Larger upfront down payments also help the lender minimize their potential losses.  If you stop paying a mortgage, the lender may write off the loan, foreclose and then try to resell your house.  But they can't always get full market value, so the smaller the loan amount, the better.  If the loan is much less than the actual value of the house, the lender stands a better chance of profiting, or at least breaking even, if you walk away from your mortgage.

The amount of the loan as compared to the actual value of the house is called the loan-to-value (LTV) ratio.  In this example, if you put 20% down, the LTV is 80%.  This is the norm when getting a mortgage.

Less Than 20% Down

If you want to put less than 20% down (resulting in an LTV higher than 80%), you have a couple options. The first is to get a "piggy-back" loan, where you take out another loan to pay the down payment. This loan will usually have a higher interest rate than your primary mortgage.

Your second option is to pay for private mortgage insurance (PMI). This insurance protects the lender if you stop paying your mortgage.  Your PMI can be tax-deductible like your mortgage interest in many instances.  Please check with a professional in the area.

Some lenders will even allow you to borrow the entire purchase price of a house (100% LTV).  You pay a premium through higher interest rates when choosing this route and you incur a significant risk.  If your house goes down in value, you could sell your house and still owe money to the lender.  This is known as negative equity and while it does happen to real estate, it's more common in cars where there is massive upfront depreciation.

When you make a down payment, your loan is less than the value of the house so you have some padding should you need to sell your house if it goes down in value.  Without a down payment, your padding becomes any money you have saved up for a rainy day.  100% LTV is a powerful tool but you need to understand the risk.

A more common scenario is 10% down (90% LTV) where your "piggy-back" loan is actually a fully-utilized home equity line of credit (HELOC).  As you payback the HELOC, you can use the available credit much like you would a credit card with a lower interest rate.  Again, HELOCs are debt and the interest charges can be significant, but they are another tool if you're disciplined with your finances.

The Thought Process

If you go into the mortgage process expecting to put down 20%, you'll generally start with some of the better rates available from that lender.  The trade-off is that many people find that it requires a large upfront investment. 

Under 20% down payments are common but it's good to start your investigation there so that you understand what your lender is willing to give-and-take.  From there, you can compare what you pay if you put less down.

This cost may include slightly higher to higher interest rates for your mortgage and "piggy-back" loan, as well as PMI.  You're getting a good deal if the difference is small.

If your credit card debt is significant, please consider paying that off before purchasing a house so that you can be more assured of living in whatever house you buy for a long time.  Real estate agents have to sleep at night too!

Interestingly, some lenders will give you a discount on your interest rate if you put down more than 20%.  (This difference in LTV should not be confused with paying points.  When you pay points, you're buying a lower interest rate for the same loan amount.  When you make a larger down payment, your loan amount is less and the lender may reward you with a lower rate.) A quick analysis of the cost savings vs. your goals will help determine if this choice is worth the reduced financial flexibility.

Recommended Reading:

• How Much House Can I Afford? (Part 1 of 2)
• Empowering Yourself Through Your Credit Rating
• Your #1 Defense Against Getting Ripped-Off on a Mortgage