If, after long bouts of debating, deciding, and redeciding, you’ve finally concluded that you’re going to take the plunge and buy a new home, this is a must-read chapter for you.
You’ve found the perfect home, in the perfect neighborhood. It’s convenient, it’s accessible to your friends, to the shops you frequent, and if applicable, to your kids’ schools. It’s got the extra bathroom you’ve always wanted, and the closets are absolutely huge. The kitchen is fabulous, with plenty of cabinet space and a work island in the middle. It’s got an entryway that you just love, and even the guest bedroom is spacious. So you’re not crazy about the color of the carpeting, but you can live with it—at least for a little while.
Getting ready to move is an exciting time, there’s no question about it. It’s also a busy time, and a very expensive time. If you don’t watch it, those expenses can add up shockingly fast.
New curtains to match the bedspread you already have. New shower curtains, too. Oh, heck. You might as well buy that sofa that you saw on sale. It will fit much better against that large wall than the smaller one you already have. And, of course, you’ll want the love seat, too. You see what we mean? In just one paragraph, we’ve managed to spend thousands of dollars.
Maybe your excitement is due to the fact that you’re buying a second home, as discussed in Chapter 12, “A Home Away from Home.” You lie awake at night, looking forward to the time you’ll be able to hear the ocean from your bedroom window.
Regardless of whether you’re buying a primary residence or a second home, there are many, many financial issues to consider. In this chapter, we’ll have a look at how you can judge what you can afford to pay for a house, and what payment method will work best for you. We’ll tell you how to determine the value of your home, and find out how much equity you’ve got in it. It’s information you’ve got to have before signing on the dotted line.
Let’s make something very clear, right away. Having a mortgage counselor deliver the good news that you and your spouse can afford to buy a $200,000 home, by no means compels you and said spouse to head out in a frantic search for such a place.
Being able to afford a particular mortgage payment on paper is a lot different than being really able to afford it. Just because a formula says you can handily pay $1,500 or $2,000 a month on your house doesn’t mean you’ve got to find a place that costs that much.
If your credit card debt has been creeping upward, do everything you can to reduce it before applying for a mortgage. Doing so will reduce your total debt and put you in a better financial position for getting a mortgage.
If you’re going to borrow money for a home, you should borrow an amount that also allows saving for your other financial goals. Are your college savings well funded and up to date? How about your retirement accounts? And don’t forget about the cash you’ll still need for entertainment, recreation, and vacations—not to mention groceries.
When you apply for a mortgage, a lender will review your net worth statement and your credit history, look at your current income, and see what sort of debt you already have.
He’ll take into consideration expenses such as day care costs, monthly parking fees, and the cost of your daily commute. Once he’s got a handle on your financial situation, he’ll assess the impact that a new mortgage will have on all that, then decide if you can afford the property.
Remember, though, just because he or she says you can afford it, doesn’t mean you want it.
Most lenders use a debt-to-gross-income ratio of between 28 and 36 percent. That means that your total debt, including mortgage, taxes, car payments, credit card debt, and so forth, should fall somewhere within 28 and 36 percent of your total income.
A couple earning $80,000 per year (that’s $6,666 per month), for instance, can have a monthly debt repayment schedule of between $1,800 and $2,400 per month. See the following table to get an idea of what you might be able to afford a month in debt repayment. Remember that your mortgage is only a part of your total debt repayment. These figures are based on a 28 percent total debt-to-income ratio.
It’s basic, but very important to keep in mind that a bigger mortgage means less money elsewhere. Unless you’re manufacturing money in your basement, you’ve got a limited amount. You may have gotten pretty comfortable with your old mortgage, or maybe even had your old home paid for. Maybe you’ve been paying all your bills, eating out whenever you wanted, and still had extra funds to put aside in savings.
Just remember that a larger mortgage payment, or a second mortgage payment, can cause your discretionary income to vanish. Think back to when you bought your first home. Remember how you scrimped and saved? Are you willing to do that again? Just be sure that you don’t overextend your finances on a new mortgage.
Don’t Go There
Don’t forget about all those extra, nasty little fees like points and settlement fees that crop up when you get a mortgage for a new home. Not planning for those costs can turn settlement from a happy occasion into an embarrassing one.
Once you figure out how much you’re able to afford (theoretically, at least), you can look at your overall financial picture and see where you might be able to cut down in order to give you a little breathing room between your increased mortgage and other expenses. Nobody likes to have to watch every nickel they spend, but you don’t want to end up house rich and cash poor (or broke).
And remember that the costs of buying and moving into a new home don’t end with the mortgage.
The cost of moving includes far more than mortgage payments and settlement expenses. When you’re thinking about moving, try to anticipate some of the extra costs that you’ll encounter. If you can, talk with somebody who’s moved recently to see what costs they ran into. Extras can add up fast, for example:
Remember to consider all the extra costs you’ll run into when deciding how much money to pay down on the house. It’s great to have a big down payment because it reduces the size of your mortgage. It’s not great, however, to be unable to afford to buy what you need for your new home.
If you’ve decided to go ahead and buy a new home, chances are that you’ll need to borrow some money, at least temporarily. If you’ve got a lot of equity built up in your current home, and are buying something that’s less expense or about the same price as where you’re living now, you may only need to borrow money for a short time. You borrow to pay for your new home, then repay the loan when your current home sells.
If you’ve always lived in an apartment, however, or are buying a second home, chances are that you won’t have the cash available to buy your home outright. Very few people pay 100 percent of the price of a home before they move in. Most folks, and chances are that you’re one of them, will need to get a mortgage and make monthly payments on their home.
Getting a mortgage sounds simple, but the problem is that there are many kinds of them out there. The trick is deciding which kind of mortgage is right for you. Get ready for a quick, crash course on mortgages, and then we’ll show you a profile of what types of mortgages seem to work best for certain types of people. You can figure out where you best fit in, and what type of mortgage you might consider.
The two most common types of mortgages are fixed rate and adjustable rate. Fixed-rate mortgages are those on which you agree to pay a certain amount of interest every month for as long as you have the mortgage. If your mortgage rate is 7 percent, you’ll pay 7 percent every month from the time you get the loan, until it’s completely paid back.
An adjustable-rate mortgage is a loan on which the interest rate varies. For that reason, your monthly payments don’t stay the same.
The interest rate on an adjustable-rate mortgage rises and falls in line with changes in overall interest rates. The typical rate changes once a year—and usually can’t rise more than two points annually or six points over the life of the loan.
Adjustable-rate mortgages generally offer lower beginning interest rates than fixed-rate loans, and you generally don’t have to pay points if you get this type of mortgage. Remember though, that points are really prepaid interest, so if you don’t pay them up front, you’ll end up paying over the life of your mortgage.
Adding It Up
A fixed-rate mortgage is one where the interest rate remains constant over the life of the loan. An adjustable-rate mortgage normally has the same interest rate for a specified time, after which the rate may fluctuate.
Some other types of mortgages include the following:
In addition to different types of mortgages, you can pay them back over different periods of time. The most popular payment periods are 15 and 30 years.
If you choose a 30-year mortgage, you get to pay less each month because your loan is spread out over a longer period of time. A 15-year loan means higher payments, but you can usually get a slightly lower interest rate. And paying the mortgage off in half the time results in big savings overall.
There are, however, some advantages to a 30-year mortgage. Mortgage interest is 100 percent tax deductible, and having a longer-term loan allows you to claim the deduction for many years. Also, if you’re paying less per month on your mortgage, you may have more money to invest.
The total interest paid on a 15- year mortgage with a 7 percent interest rate is $46,350. Total interest on a 30-year loan at the same interest rate is $104,632. Big difference!
The Pennsylvania Institute of Certified Public Accountants has come up with a set of mortgage guidelines, based on a borrower’s profile. Read it over and see where you think you fit in, and what type of mortgage may be best for you.
Today’s adjustable mortgages don’t offer the really big initial savings that they did in the past. Even the Mover might be better off locking in a low long-term rate through a fixed mortgage.
Adding It Up
Fannie Mae is a security issued by the Federal National Mortgage Association, which is backed by insured and conventional mortgages. Monthly returns to holders of Fannie Maes consist of interest and principals payments by homeowners on their mortgages.
These profiles can give you an idea of what type of mortgage may work the best for you. It’s a good idea, though, to talk to a mortgage counselor or your accountant before making a final decision.
If you’re thinking about buying a vacation home and you have built up a fair amount of equity in your primary home, you might think about getting a home equity loan.
Loans based on the equity in your home generally can be obtained at lower interest rates than nonsecured loans, and the interest is normally tax-deductible.
If you need cash out of your home, you probably don’t have to refinance into a new first mortgage. Consider adding a second mortgage or getting a home equity loan. Second mortgages are loans you get on top of your primary mortgage, and they’re not part of the national market. Held by local lenders, the interest rates on them can vary tremendously, so be sure to shop around.
Home equity loans are generally paid back over a much shorter time period than mortgages. Review your entire loan situation with your lender, looking at whether it’s best to refinance everything into one loan or to add a home equity loan to your first mortgage. The lender will be able to provide you with comparison costs and total interest paid.
Using your home as collateral for a loan puts your home at risk if you should default. You should carefully assess your borrowing needs and your ability to repay before you decide to borrow against your house.
There are two types of equity loans. The first, a fixed, lump sum amount, is known as a home equity loan. Usually taken out for a car or home improvement project, there is a fixed term to the loan. That is, the interest rate and your monthly payment will remain fixed over the life of the loan.
An equity line of credit enables you to draw against a credit line as the need arises. You can pay for the kids’ braces, car repairs, or whatever. Instead of borrowing a fixed amount of money, a line of credit qualifies you for a certain amount of credit. You can borrow up to your credit limit, if needed, but you don’t need to. The monthly repayment amount depends on what you’ve borrowed and the interest rate charged is variable. Lines of credit generally carry higher interest rates than home equity loans.
If you’re interested in an equity loan, be sure to do some comparison shopping. Lending institutions are competing fiercely with one another to sell home equity loans. Find a lender that charges a good rate, with minimal fees.
A swing loan is a mortgage loan necessary to tide you over when you need to buy a property while you already own another one. Some cases in which a swing loan comes in handy might be when one spouse gets a new job and goes off to the new location while the rest of the family stays behind. The spouse who’s already moved finds a great house, flies the rest of the family out, and they agree to buy it, despite the fact that their original home isn’t even up for sale, yet.
Or perhaps you have no intention of moving, but quite by accident, you find the house you’ve always wanted. You’re afraid of losing your dream home, so you make a bid and start looking for a swing loan.
Swing loans are interest-only loans, using the first property as collateral for the second property. They’re usually executed as equity loans on first property.
Swing loans require you to sign a mortgage note that collateralizes the first house. You’ll pay interest only until the first property is sold. When you sell the property, you repay the loan and satisfy the mortgage.
Construction loans are available to finance new construction. You can be a first-time homeowner and need a construction loan, or you can already be a homeowner who requires one while you build a second home.
The bank agrees to give you a specified construction mortgage, usually with four equal draws or payments to the contractor. When the contractor requests a draw, an inspector is sent to the property site to verify that the builder has completed everything that’s been agreed upon to date.
To request a construction home loan, you’ll need to take your building plans and a purchase contract to your lending institution. Although all lending firms are different, most require an initial settlement, which is held in escrow until spent.
A construction mortgage is interest only while the property is being built. Once the construction is completed, the bank has a formal settlement, any overages are accounted for, and a standard mortgage (with principal repayment and interest) begins.