Tuesday, July 3, 2007

Home Buying Series Part III: How Much House Can You Afford?

How much house can I afford? It seems too many home buyers forgot to ask that question before they got caught up in the buying bonanza of the last few years. That's why foreclosure rates are spiking. A lot of people fell in love with a house and then asked their lender how they could afford it. During a period of incredibly loose credit lenders were happy to oblige and put people in houses they couldn't afford using low or no doc loans, interest only loans, neg am loans, and little or nothing down.

How Not to Become a Statistic

There are generally three criteria for getting a conventional loan without mortgage insurance:
1) You have to make a 20% down payment on your house
2) Your monthly mortgage payment (including interest, principal, taxes, and insurance) can't be more than 28% of your gross income.
3) Your total expense obligations (i.e. your mortgage + all other debt payments) can't be more than 36% of your gross income.

It turns out if you stick to these rules you are much less likely to end up in foreclosure than someone who strays from them. For instance, if you look at the most recent Mortgage Banker's Association survey you can see that subprime and FHA borrowers (who typically have bad credit and make minimal down payments) have much higher delinquency rates (around 13%) than those with conventional mortgages (less than 3%). Now this is probably not an entirely fair example because subprime borrowers usually have bad credit to begin with so they are probably more likely as individuals to default on their mortgage anyway, but general idea is correct. Prime borrowers could afford their mortgages and subprime borrowers generally could not which is why 13% of them are delinquent.

Many people will tell you that you don't need a 20% down payment on your house. I disagree for three reasons. First, if you can save the 20% down payment, you probably have the financial discipline to make your mortgage payment. Second, that 20% provides you a cushion from an unusually soft housing market (which is what we are currently in). If you only put 5% down and then the value of your house declines by 10% you will actually owe the mortgage company money if you decided to sell right then. Real estate prices rarely fall by 20% so you should almost never run into this problem if you put 20% down. Finally, if you put down less than 20% you need to pay for mortgage insurance (typically adds 0.5% to your interest rate) which is a totally ridiculous thing to do in my opinion if you have every intention of paying your mortgage.

To get an idea of how much house you can afford, I recommend trying this mortgage calculator from CNN Money. It will tell you how much house you can afford based on your income, debt, and the interest rate you think you can get on a loan. It conforms to the 28% mortgage payment rule and the 36% total debt service rules. It also assumes you will put down 20% and avoid paying mortgage insurance as a result. For a quick view of what interest rate you might expect to pay visit Bankrate and look at the rate on the 30 year fixed mortgage.

Finally, to learn a lot more about mortgages visit The Mortgage Professor. His site is so in depth you might find yourself drowning a bit, but you will find the answer to almost any question there.

As always the Armchair Fiduciary is happy to field your quesitons. Email me at armchairfiduciary_at_gmail.com.

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