CHAPTER 2
How to Know How Much Home to Buy
Knowing how much home to buy is just as important to you as it will be to the lender. Lenders have a comfort range of how much your house payments can be, based upon current interest rates and the amount of money you want to borrow. On the other hand, what is important to you simply might be what you feel comfortable paying every month.
2.1 HOW DO I KNOW HOW MUCH I CAN BORROW?
That depends on a variety of factors, but the most common answer is that your debt ratios are in line with lending guidelines. But it may also be more than that. It may just be the amount that you feel comfortable with. Often when I’ve prequalified clients, typically first-time home buyers, they’re surprised at how much money a lender will lend to them. “Oh gosh, no. I don’t want that much money!”
Still others are disappointed that they can’t borrow more than the lender feels comfortable with, using the very same loan parameters. What’s good for one borrower may not be good for another.
Different mortgage programs can have different lending guidelines, but for the most part these programs decide how much you can borrow based upon debt ratios. It used to be that debt ratios were relatively strict. If a ratio were above 41, for example, the buyer would either have to borrow less or find a cheaper house.
2.2 WHAT ARE DEBT RATIOS?
This is the most significant concept in lending today. And maybe the most misunderstood as well. Consumers are told time and time again about their “debt ratios.” They hear mystical numbers tossed around, like 28 percent and 41 percent “back end” (note that every lender has different debt ratios).
Debt ratios are a percentage of debt compared to income. If you have a debt ratio of 10, then your bills represent 10 percent of your gross monthly income. Over the years, lenders have relied on historical data to set guidelines that tell them which particular ratio allows the lender to make the biggest loan to someone while at the same time making it a “safe” loan for the consumer, meaning the lender won’t have to foreclose on the house due to nonpayment.
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A lender is in the lending business, right? If lenders can make the biggest loan to an individual, they probably would. After all, there’s a big difference between collecting the interest payments on a $10,000 auto loan and a $200,000 mortgage. So it behooves the lender to make larger loans in order to collect larger interest payments. But the lender has to be careful not to lend too much money. Sure, making a $200,000 mortgage loan yields a greater return to a lender than a $100,000 loan. But what if the higher loan made the monthly payments too high and the borrower fell behind on the mortgage?
The lender has to find a balance between making the largest loan possible and at the same time feeling comfortable about getting repaid in a timely manner. That’s where ratios come into play. Instead of evaluating each and every loan application individually, lenders have determined that loans with certain debt ratios are less likely to go into default than higher debt ratios. Historically speaking, that is.
2.3 HOW DO I CALCULATE MY DEBT RATIOS?
Debt ratios are two numbers expressed as a percentage of your gross monthly income. The first debt ratio is called your housing ratio because it only uses your house payment (which includes your monthly tax and insurance payment) for the ratio. This ratio is often also called your “front end.” The second ratio is your housing ratio plus any other debt listed on your credit report, divided by your gross monthly income. This is sometimes called the “back end” ratio or total debt ratio.
Common front and back ratios on conventional loans with 5 percent down are 28 percent and 36 percent, respectively. Take your gross monthly income and multiply that number by 28 percent, then use the “cost per thousand” chart in the Appendix at the back of the book to find what a lender would consider a comfortable house payment.
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For example, your gross monthly income is $5,000. Remember, this is your gross income. Income before all your taxes and withholding are deducted. Let’s say that the typical housing ratio is 28 percent, historically a common housing ratio for borrowers with 5 percent down. So 28 percent of $5,000 is $1,400.
Included in that $1,400 is your monthly hazard insurance bill of $75 and your monthly tax payment of $125. Also note that if you put less than 20 percent down you’ll need a private mortgage insurance premium as well, which might be $85. By subtracting these amounts from your “allowable” $1,400, you’re left with $1,115 for your principal and interest payment. For a 30-year fixed payment of $1,115 and a note rate of 7 percent, the loan amount calculates to about $168,000. You’re prequalified to borrow $168,000. Give or take. Again, this is your front-end or housing ratio.
Note that this has nothing to do with the sales price of your new home but only pertains to how much you’re going to be able to borrow. If you have a $168,000 loan amount, that doesn’t mean you have a $168,000 sales price. You can have a million-dollar home with just a $168,000 loan amount, as long as you have $832,000 in down payment, right?
The second ratio, or back-end ratio, is your total debt ratio. It includes mostly those items that would show up on your credit report, such as automobile loans, minimum credit card payments, student loans, and the like. Other things you pay for but that are not included in your ratios are your electricity, telephone, and food expenses.
If you had a car payment of $400 and student loan payments totaling $250, then in this example your ratios would be $1,400 + $400 + $250 = $2,050. Divide that by your gross income of $5,000 and your back-end ratio is 0.41, or 41 percent. Your overall ratios would be 28/41.
2.4 HOW MUCH DO DEBT RATIOS AFFECT HOW MUCH I CAN BORROW?
There are debt ratio guidelines for almost every loan program, but they’re only guidelines, not hard-and-fast rules. Different loan programs have different ratio rules. Even the same loan program can have different ratios depending on the amount of the down payment. In fact, throw those “rules” out the window, because that’s not how it’s done any longer. Okay, maybe some rookie loan officers or the otherwise uninformed adhere strictly to the guidelines, but it is not the practice of the industry as a whole. Knowing how much home to buy can be more of a comfort factor than anything else.
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Don’t make the mistake of “preapproving” yourself before you talk to a lender. If you’ve read or heard that a house payment needs to be one-third of your gross monthly income, don’t start the process by looking at homes that fall into that price range. If you have no idea whatsoever of how to get a comfortable debt ratio, you should start out by comparing it to what you’re paying now.
If your rent payment is $1,500 per month and you feel comfortable paying it, then certainly start with that number. If you’ve struggled with paying $1,500 every month, then perhaps you need to reduce that debt load to something that doesn’t make you sweat each time you write the mortgage check. On the other hand, you might be paying $1,500 per month in rent but feel as if you can comfortably pay $3,000 per month in house payments. If you feel good about that number, then by all means, start from there.
One note of caution, though: Lenders have a term called payment shock, which is the percentage difference between what you’re paying now and what your new payment would be. Most loan programs don’t have a payment shock provision, but for those that do, a common percentage increase is 150 percent. For example, if you’re used to paying $1,500, then your maximum payment shock amount would be 150 percent of $1,500, or $2,250. Even though you may feel comfortable paying twice what you’re paying now, payment shock guidelines suggest that would be a risk.
Payment shock is an underwriting guideline. For loans that do have a payment shock provision, there is a definite shock percentage listed in the loan guidelines. To exceed the shock guideline, typically the consumer has to get a loan exception. Loans that do have a payment shock provision usually consider it only when evaluating a loan that’s teetering on loan approval.
If you have absolutely no idea what your house payment should be, then you should be talking to your lender. Ask the lender to qualify you, based upon debt ratios, for a home loan. The lender will take your information and—using current interest rates, hazard insurance premiums, and property taxes—come up with your allowable loan amount. But whatever you do, don’t “decline” your own loan application by not applying for what you really want. Too often people haven’t made an offer on their “dream home” simply because they figured their debt ratios to be 35 rather than 33.
After taking one loan application from a woman buying her first home, I could tell before I submitted the loan that her debt ratios were too high. How high? Her back-end ratio was 55 percent. She was biting off more than she could chew; her loan amount was $250,000. I put the loan onto the system and within thirty seconds got my result: caution. But the difference lies in what happens next.
In the recent past, borrowers would sit down with their loan officer and the loan officer would run some numbers and “tell” them what they could buy. Instead, I ran different scenarios through the computer, each time gradually reducing the loan amount and her debt ratio. After about five tries, I got her approval of $230,000 and yet her debt ratios were in the high 40s.
Just a few short years ago, she would have never even gotten to the application stage because of debt ratios. Are her ratios high? Probably so, but she felt comfortable paying them, and had a good down payment and excellent credit history.
2.5 HOW CAN LENDERS APPROVE PEOPLE WITH HIGH DEBT RATIOS?
Not all of them do every time. The new sheriff in town is an Automated Underwriting System (AUS). Whereas debt ratios are used to test a historical “affordability” model, an AUS evaluates the complete picture all at once.
It used to be that if your ratios were above 38 on many loan programs, a lender might ask that you buy a smaller home or borrow less money. That’s because, actuarially speaking, higher debt ratios point to a greater likelihood of default. However, with the fine-tuning of Automated Underwriting Systems, often these ratios come to mean less and less in terms of qualification. Fannie Mae and Freddie Mac own the most common Automated Underwriting Systems. Ratios aren’t disregarded, but they’re less of a rule and more of a guideline.
An AUS is nothing more than a sophisticated software program designed for lenders to approve loans faster and make more money. So there is no reason not to submit an application to an AUS at the very beginning of the process. If there are major discrepancies in the file, then sure, identify a potential problem like missing coborrowers or no income, but submit your application nonetheless. It’s this information that’s used to not only approve the loan but also determine the “degree” of approval.
A degree of approval doesn’t mean “almost approved” or “maybe approved.” You are approved altogether, with the difference being how much documentation is required as a condition of loan approval. Someone with very high credit scores, a down payment of 20 percent or more, and lots of money lying around will be asked for a lot less documentation than someone with marginal credit, 3 percent down, and high ratios.
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First and foremost, AUS programs place a greater consideration on a customer’s credit. If your credit score is in the high 700 range, then you can expect your ratios to be relaxed.
The next most important consideration is reserves. Reserves are a borrower’s assets after closing, and they can include things other than cash in the bank, including stocks, mutual funds, IRAs, and 401(k) accounts. The higher the estimate of your reserve balance after closing, the higher your “affordability index.”
The last important consideration is your equity position in the house, or loan-to-value (LTV) percentage. If you only put down 5 percent, then don’t expect your ratios to go beyond loan guidelines. But if you put 20 percent or more as a down payment, then you may be able to go ahead and borrow a little more than you thought you could.
I recently closed a loan where the primary borrower had a credit score in the 580 range and still got the best rates available. The main factor had to do with the equity in his home. Yes, the credit score could have been higher, but the value of the home was nearly $500,000 and his loan amount was less than half that (a strong equity position). One word of caution, though: Many times what borrowers qualify for exceeds their comfort level. Just because you can borrow with debt ratios in the 60s doesn’t mean you should, especially if you can’t sleep at night worrying about making the mortgage payments. If, however, you feel confident in your ability to pay, then by all means don’t let a ratio guideline thwart your new home search. You may still be able to buy your dream house, even though it seems out of your range.
2.5A HOW TO LOWER YOUR DEBT RATIOS
There are ways to lower your debt ratios in order to help qualify beyond simply borrowing less or coming up with a larger down payment. First, you can adjust your loan term. Or, you can elect to switch from a fixed-rate loan to a hybrid product. Hybrid loans are a form of an adjustable-rate mortgage where there is an initial fixed-rate period before turning into a variable-rate loan that can adjust annually. Hybrid loans have lower start rates. Or, you can decide to pay a discount point and lower the starting rate on your loan. You may also look at paying down current credit obligations, reducing your overall debt ratios. We’ll discuss these options in more detail in Chapter 7.
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With regard to loan terms, the longer the term, the lower the monthly payment. There are borrowers whose goal is to save on interest when they borrow so they select the shorter loan term. Paying off a loan sooner rather than later saves on long-term interest. Yet the monthly payments are higher due to the shortened term. If debt ratios are too high, look at a longer-term loan. Lenders typically offer terms in five-year increments from 10 to 30 years. If a 15 is too high but long-term interest savings is still your goal, look at a 20-year or a 25-year loan. Many consumers aren’t aware of these choices primarily because lenders usually advertise their rates in 15- and 30-year terms.
Hybrids and adjustable-rate programs will have lower starting rates compared to a fixed-rate option; yet because the rate isn’t fixed for the term of the loan, the rate in the future can and will vary at times. For example, with a 5/1 hybrid ARM, the rate is fixed for five years before turning into a variable rate that can adjust annually.
2.6 WHY DO LENDERS USE MONTHLY TAX AND INSURANCE PAYMENTS IN DEBT RATIOS?
If you’re paying for taxes and insurance in addition to principal and interest, that indeed affects your ability to pay your bills on time.
Your monthly tax and insurance payments are also called escrow accounts or impound accounts. Each month when you make your house payment, you will also pay 1/12 of your annual tax bill and 1/12 of your annual hazard insurance premium. When your insurance comes due one year from now, your lender will automatically make your insurance payment for you. The same goes for your taxes. When determining your ability to pay your mortgage, lenders use the more realistic number, which is the total payment you actually make. Further, for loans with a monthly mortgage insurance payment, that amount is also factored into the debt ratio calculation as are any monthly homeowner’s association fees.
2.6A WHAT IS AN ABILITY TO REPAY?
This is a relatively new term that describes the lender’s requirement to determine whether the borrowers on the loan application have the ability to repay not only the new mortgage payment, including taxes and insurance, but also the other, additional monthly credit obligations such as a car payment. The Ability to Repay, or ATR, is mandated by the Consumer Financial Protection Bureau, or CFPB. Should lenders want to protect themselves against future lawsuits as a result of a loan dispute and the lender followed the prescribed guidelines, the lender is protected if the ATR is documented. The ATR on most loan programs represents 43 percent of the borrower’s gross monthly income.
2.7 WHY IS ESCROW A REQUIREMENT FOR LOANS WITH LESS THAN 20 PERCENT DOWN?
Loans with less than 20 percent down are at a higher risk of default than those with more than 20 percent down. And from a performance standpoint, loans with escrows don’t default as often as those without. Less money down means greater risk to the lender. Some of that risk is offset knowing that the collateral is always insured and that the borrower never falls behind on his property taxes.
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At the end of the year or twice a year, whenever your county collects property taxes, your taxes are paid automatically by your lender, who has an escrow account set up for you. So there’s no pain when tax time arrives. If your debt ratios are in the 40s or 50s and you put 5 percent down when you bought the house, the property tax bill will be paid—no sweat. It works sort of like a Christmas club for taxes.
The same goes for your hazard insurance premium. When your home insurance premium comes up to renew your policy, the money’s already there to pay your insurance agent. You’ve already saved it up, bit by bit, over the past year.
Lenders spend a lot of time analyzing risk. They don’t want to have to make sure you have enough money to pay your taxes on time. If you don’t, then tax liens start appearing on your title; ultimately, your home can be sold out from under the lender if your taxes become seriously delinquent. Your lender sleeps better at night when you have an escrow account.
In fact, they sleep so much better that they sometimes “pay” you to take escrow accounts, even if you’re not required to have them if you put more than 20 percent down. How’s that? In certain parts of the country, when borrowers have more than 20 percent equity in the deal, it’s customary for lenders to give them a 1/4 point discount if they elect to take escrow accounts. On the flip side, lenders may charge you 1/4 point if you don’t take them. This is sometimes called an “escrow waiver” fee.
When you set up an escrow account, your lender will ask for not more than two months’ worth of property taxes to be deposited with them. Federal law requires that there be no more than a couple of months of payments plus fifty bucks to establish the account. This “cushion” is there in case property taxes increase during the course of the year. Some lenders, however, do not require any escrow account to be funded at the closing table and will collect only the first month’s payment with no cushion required. This is completely at the discretion of the lender.
Your local appraisal district has its own army of appraisers whose job it is to evaluate property and determine your property tax bill. One word of caution here: If your home is brand new, the property valuation may have been performed prior to your home being built, when it was just raw land with no improvements. If this is the case, and your taxes appear to have been appraised just for lot value, when your tax bill comes due you may be woefully short, because property taxes will indeed be for the improved value, not just raw land.
2.8 IF I HAVE A CHOICE, ARE ESCROWS RIGHT FOR ME?
Escrow accounts are neither good nor bad. Lenders like them. Whether to take them is a different issue, and mostly a matter of personal preference. If you would rather pay your taxes and insurance on your own when due and invest the money elsewhere for the time being, go right ahead. If you feel more content having saved up your property taxes and hazard insurance in tiny chunks, then knock yourself out. It’s more a matter of how you view escrows, not what a lender thinks of them.