My wife and I purchased our first home five years ago, which was not nearly as fun as an episode of HGTV’s House Hunters makes it out to be. After actively searching for months and putting offers in and losing out on six different houses, we finally grabbed the brass ring with our new home. To do that, we had to beat out seven competing offers after seeing the home for only 20 minutes during an open house on its first day on the market. Overall, it was a stressful experience, but we ended up with a beautiful home that has served our family well. While we have not jumped back into today’s real estate market, the conditions sound like what we faced all those years ago.
One aspect of the process that I was able to control was our mortgage application. Going through the process myself made me realize how truly confusing it can be. There are many factors to consider when obtaining financing for your home.
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The first thing to determine is how much you can spend on your new home. The amount that you can borrow will generally depend on four main factors: 1) the size of your down payment; 2) your credit score; 3) your debt-to-income ratio and 4) your monthly maintenance expense. All these factors will impact the interest rate you can obtain from your lender and the size of your monthly payment, which should correspond with your overall cash flow so that you can continue to live without feeling like you are chained to your new home (“house rich and cash poor”).
Your down payment is the amount of money you already have saved to buy your new house, typically between 5-20% of the purchase price of the home. If you are obtaining a conforming loan and putting less than 20% down, you may be required to obtain private mortgage insurance (PMI) which protects the lender in case of default.[i] On average you will also need an additional 2-5% of the purchase price to cover closing costs and other expenses such as attorney’s fees, appraisal fees, mortgage recording fees, transfer taxes, title insurance premiums, etc.
Your credit score, or FICO score, is derived from the information found on your credit report as reported by the three major credit bureaus (TransUnion, Equifax & Experian). Each bureau generates a separate FICO score ranging from 350 to 850, and you should review each one before applying for a mortgage. Your credit report includes:
- Payment history (Have you made payments consistently and on time?)
- Debt utilization percentage (What percentage of your available credit are you currently using?)
- Length of credit history (How many years have you been borrowing?)
- Types of credit (Do you have a mix of credit cards, student loans, car loans?)
- Applications for new credit (Have you applied for new lines of credit in the recent past?)
- Negative comments (Do you have any outstanding judgments, liens, or recent bankruptcies?)
- You can expect to obtain competitive mortgage interest rates if your score is 720 or above, which may allow you to borrow more than you otherwise would have.
Debt to Income
Your debt-to-income ratio (DTI) is expressed as a percentage and is calculated by taking your monthly debt and dividing it by your gross monthly income. For example, if you have a student loan payment of $750 per month, a car payment of $325 per month, a minimum credit card payment of $120 per month, and a gross income of $12,500 per month, your DTI (before your mortgage) would be 9.56% [($750+$325+$120)/$12,500]. A DTI of less than 36% can qualify for most mortgages – the lower your DTI, the more you can potentially borrow for your new home. In the above example, you could add a maximum monthly mortgage obligation of ~$3,300 to obtain a DTI of 36%. Typically, however, it is inadvisable to obtain a mortgage that equates to your maximum monthly obligation as it will severely limit your ability to save towards your other financial goals.
Your monthly maintenance fees are comprised of all the expenses that go along with homeownership that are not factored into your monthly principal and interest payment. Some items, like your property taxes or homeowner’s insurance, may be escrowed by your mortgage provider.[ii] Other costs, like utilities, association dues, and other upkeep may fluctuate from month to month but should be considered as part of the overall cost of your home.
Another important factor to keep in mind are the rules governing the deduction of mortgage interest on your federal income taxes. For a “qualified home,” the IRS allows an individual to deduct the interest charged on up to $750,000 of home acquisition debt (used to buy, build, or improve a home). This is an itemized deduction, meaning all your itemized deductions combined (up to $10k of State and Local Taxes, Charitable Contributions, Qualified Mortgage Interest, etc.) must be more than your standard deduction for it to make sense to itemize. In 2021 the standard deductions are:
- Married Filing Jointly - $25,100
- Single/Married Filing Separately - $12,550
- Head of Household - $18,800
For example, if a married couple who file jointly were to purchase a $625,000 home with 20% as a down-payment, they would finance $500,000 via a mortgage. Assuming they get a 30-year fixed mortgage at 3%, the first year’s worth of interest payments would be ~$14,000. Further assuming they get the maximum SALT deduction of $10,000, they would still need at least an additional ~$1,100 of tax deductions before their itemized deductions would be greater than the $25,100 standard deduction they would obtain anyway.
To the extent you can deduct the interest paid on your mortgage, in turn reducing your income tax burden, you may be able to increase the purchase price of your home.
Types of Mortgages
Once you have your purchase price in mind, the next decision you should tackle is what type of mortgage product you should obtain. There are many different types of mortgages, but they generally fall into two main categories: 1) fixed rate mortgages, in which the interest rate is fixed for the life of the loan; and 2) adjustable-rate mortgages (ARM), which adjusts based upon the rate of an underlying index following the completion of a fixed-rate period (3-10 years on average). Typically, the interest rates for ARMs are lower than those for fixed rate mortgages because the lender assumes less interest rate risk.
Generally, you want to match the fixed rate period of your loan to the time you will be in your home. Remember that when you sell your home, you do not have the ability to take your mortgage with you. Why pay more for a 30-year fixed rate when you anticipate moving in the next 5-7 years? Alternatively, if you are looking at your “forever home,” then a 30-year fixed can make a great deal of sense, especially in today’s comparatively low interest rate environment.
It also may make sense to consider interest-only loans, in which the principal balance of the loan does not decline as payments are made during a period, depending on your individual circumstances.
The decision to buy a home should not be entered into lightly. It is a major decision that brings with it many consequences. Luckily, with a little planning, some guidance, and a pinch of optimism, you, too, can accomplish your dream of home ownership.
Article By Eric Dostal, J.D., CFP®
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[i] A conforming loan is a loan that meets all the requirements set out by Fannie Mae and Freddie Mac. Fannie and Freddie are organizations that were created by Congress to create stability in the mortgage market by acting as mortgage buyers. This provides mortgage originators, banks, and credit unions with the liquidity they need to issue mortgages. Generally, if you borrow $548,000 or less (this can increase to $822,000 in some high-priced markets) your loan will be considered a conforming mortgage.
[ii] An account can be set up by your lender to collect monthly payments of property taxes and homeowner’s insurance premiums and then paid on your behalf, typically annually or bi-annually. The costs of these items are part of your monthly mortgage payment.