Frequently Asked Financing Questions
Several of the questions below were submitted via email. I have included the complete question AND my complete response.
New! I have created an Excel spreadsheet that will help you determine your maximum monthly payment, and that will calculate the monthly payment for any house. Even if you have not expertise in using Excel, you simply click the link, open the file, and fill in the blanks. You must have Microsoft Excel installed on your computer to open this file.
Click here to open the spreadsheet.
Since most prospective home buyers do not wish to set themselves up for financial ruin, it is important to determine how much house you can afford before getting too far into the house hunting process. The two most important questions to answer are:
Lenders determine the answer to the first question, while you must determine the answer to the second question. Let's tackle the first question first:
- How large a mortgage do I qualify for, and at what rate and terms?
- How much do I feel comfortable spending each month?
When my wife and I purchased our first home, the entire mortgage lending process was a mystery to us. When we sat down to go through the financial pre-qualification process with the loan officer at a local bank, we had no clue about what sorts of mystical formula the loan officer used to determine how much we could afford. He asked us several questions about our debts, income, and credit. While we answered the questions, he scribbled furiously onto a legal pad. When he was done, he sent us home with a photo copy of the page from the legal pad. Even if the writing had been legible (and it was nowhere close to legible), we never could have figured out how he arrived at the maximum purchase price we could afford. In an effort to save you from this same confusion, I will try to provide you with a detailed--but simple--explanation mortgage lending guidelines.
Author's update: The information below, while still relevant, has changed since I wrote this section a few years ago. It is now easily possible to obtain financing that pushes ratios much higher than those described below.
Although rates and closing costs will vary somewhat from one lender to the next, all lenders will use the same uniform guidelines for determining your ability to qualify for a conforming conventional mortgage. Here they are in a nutshell:Provided that you have a good credit history and adequate down payment funds, you will qualify for the purchase of a home with total monthly costs as high asHere's what that means:1. 28% of your gross monthly income
--OR--
2. 36% of your gross monthly income less all monthly debt payments--whichever is less!If you are completely debt-free or have only minimal debts, it stands to reason that you should be able to afford a larger house payment than someone with the same income but who is saddled with a bunch of monthly debt payments, right? RIGHT! After all, you have more of your income available each month to spend as you please (i.e., discretionary income). That's where the 28% rule (also known as the "font-end ratio") comes from. Modern mortgage lending guidelines assume that you will need to spend most of your income on required expenses, such as food, clothing, insurance, utilities, taxes, etc. Keeping this in mind, lenders figure that you should be able to afford up to 28% of your gross monthly income (before any taxes or other deductions) for your housing payment, while still having enough of your income available to pay your other bills. For example, Danny Debtfree has no debts and has a gross monthly income of $3,000. Therefore, Danny qualifies to spend up to $840 per month (28% x $3,000) on housing.
If you have all the normal required expenses, PLUS you have quite a bit of debt, then lenders figure that you can afford to spend up to 36% of your gross montly income on all of your debts and housing expenses combined, while still meeting your other financial obligations (also known as the "back-end ratio"). This means that to determine how much you can afford for your house payment, you must calculate 36% of your gross monthly income and then subtract out all of your other monthly debt payments. Here's how that might look for a typically borrower:
Carrie Credit earns a gross monthly income of $3,000 (just like in the debt-free example above). Unlike Danny, however, Carrie has several debt payments that she must make each month:
A store credit card with a minimum payment of
$75 A car loan with payments of $250 Student loan payments of $60 A Visa card with minimum payments of $100 Total Monthly Debt Payments $485 You may have noticed that the person with no debt could actually be at a disadvantage. Even though Danny Debtfree has no debts, he is still not allowed to spend the entire 36% on his house payment--only a maximum of 28%. If you do some arithmetic, you'll see that Danny could spend up to 8% of his gross monthly inome on debt payments and still qualify for the 28% maximum housing payment. Basically, these mortgage lending guidelines figure that--regardless of your other debts--your housing budget should not consume more than 28% of your gross monthly income.Since Carrie is not debt-free, she must calculate her maximum affordable house payment using both formulas--taking whichever result is less. Carrie's maximum affordable house payment is figured as follows:
Back-End Ratio
36% of $3,000 gross monthly income = .36 x 3,000
= $1,080 Less total minimum monthly debt payments - $485 Total Allowable Housing Payment $595 Front-End Ratio
28% ir gross monthly income = .28 x $3,000
= $840 Since traditional lending guidelines require using whichever formula produces the lesser amount, Carrie would be able a maximum total house payment of $595.
Before moving on, here are some other factors to keep in mind:
The fine print: The material on this page is intended for example purposes only and is not a commitment for financing. These guidelines are intended for use on primary residences. Your mortgage amount and price range will vary depending upon the size of your down payment, the specific terms of your loan, other monthly obligations, and the amount of association fees, if applicable.
If you receive child support, you can probably count that as additional income. If you pay child support, you'll either have to deduct it from your income or count it as a monthly debt payment.
In the few years since I wrote the section above, a myriad of new mortgage programs, and liberalization of lending guidelines on conventional products--has resulted in many options for matching buyers with programs that offer "expanded ratios," which would allow much higher ratios than those described above. Be careful, however, not to overextend yourself financially with such programs. Regardless of how much a bank is willing to lend, you mus be certain that your house payment fits comfortably within YOUR budget.
Total Monthly Payment Defined...Your total monthly housing payment consists of more than just your mortgage payment. Your total payment has four parts, which banks often refer to as "PITI." Those four parts are:
- Principal: the portion of your payment that actually reduces the size of your total debt on the property.
- Interest: this portion of your payment represents the cost of the money that you borrowed to purchase your home. Remember that this type of interest is not necessarily bad, since most homeowners can deduct all interest payments on their primary residence from their taxable income.
- Taxes: The monthly amount that must be budgeted (or paid into an escrow account at the bank) to pay the property tax bill for the property, equal to 1/12 the annual tax bill. This portion of your payment is tax-deductible, too!
- Insurance: The monthly amount that must be budgeted (or paid into an escrow account at the bank) to pay the annual homeowner's insurance bill for the property, equal to 1/12 the annual insurance premium.
Turning Your Monthly Payment Into a Purchase Price...While it's a real thrill to know your maximum monthly payment (so thrilling that I can barely type J), it's an even greater thrill to know how expensive a home that monthly payment will let you buy. To figure this out, there are three basic steps:
The trickiest part of this process is turning your maximum affordable principal and interest payment into a mortgage amount. It requires a somewhat complicated financial function that you can see derived here. For people who are not math or finance junkies, use this online calculator to automatically figure out how much house you can afford. When you access the online pre-qualification calculator, here are some good sample values to use for some of the fields:
- Figure out what portion of your payment will be required to pay for taxes and insurance.
- Calculate your maximum mortgage amount, based upon current interest rates, loan term, and the amount of your payment left for principal and interest (the mortgage payment portion of your total housing expense).
- Add your available down payment to your maximum mortgage size.
Now that you understand how the banks determine how much you are allowed to spend, let's consider how much you should spend. The answer to this question is a very personal one that you will have to decide for yourself. If you have no kids, few debts, and you anticipate that your income will rise each year in the future, then you might feel perfectly comfortable with the largest mortgage payment the bank will allow. On the other hand, you might have kids, be maxing out your 401(k) at work or your IRA, and be saving for a major purchase (other than a house). If you have many other financial obligations, you may not feel comfortable spending even close to what a lender is willing to loan you. Be sure you spend some time getting a good feel for your total financial status and outlook before getting married to an oversized house payment for the nest 30 years!
- Annual Income: Note that this asks for an ANNUAL figure, not monthly.
- Monthly Debt: Note that this requires a MONTHLY figure.
- Property Tax Rate: For the Champaign County area, try using 2.5. This corresponds with an annual tax bill of $2,500 for a $100,000 house, which should provide you with a conservative estimate of your projected annual tax bill.
- Home insurance rate: Try using .35 for a good conservative estimate. This corresponds to annual premiums of $350 per year for a $100,000 house.
- Since market rates for home mortgages change from day to day (and even within an individual day), I will not suggest to you an appropriate figure here. Just remember to be realistic; you do not want to set yourself up for disappointment.
Back to FAQ main page Email Matt Difanis
Is it a good idea to make
extra payments; that is, to prepay principal on my mortgage?
Question via email on April 25, 2000
On the 30 year mortgage, 8.5% Fixed example below, you mentioned payments of $708.33 would "tread water", yet actually payments would be $768.91 and you would slowly meet principal requirements. What if I simply voluntarily paid $800 every month? How would the additional money be applied? Would this significantly shorten my loan term?
Absolutely. To calculate the term of the loan with your proposed $800 monthly payment, I replace the $768.91 with $800, and I solve for the number of periods (i.e., months) required to bring your $100,000 mortgage down to $0. At $800 per month, you would pay off the mortgage in about 307 months, rather than in 360 months. Essentially, you increase your monthly payment by a mere 4% per month, and you reduce the term of your loan by about 15%.
Do you think this is a good idea or not???
This question is both excellent and common. You must make this determination because the factors that you must consider are unique to you. Ultimately, all of the major factors that you must consider boil down to your level of risk tolerance or risk aversion. Below is a quick profile for mortgagees who would act differently based upon their personal preferences:
Nervous Nellie
I love security, and I hate taking risks. If I prepay principal on my 8.5% mortgage, I save interest charges for every dollar I prepay. That means that I essentially have the chance to make a guaranteed 8.5% return on those prepayment dollars (a bit less when you consider that the 8.5% is reduced due to the tax deductibility of that interest). I build up equity in my house faster, and I feel more secure knowing that I am knocking out that evil mortgage that stands between me and free-and-clear ownership of my house.
In addition to paying my house off faster, my principal prepayment puts the money to work AND it keeps me from being tempted to spend it later. I can't get enough of Bingo night at my church. If I have extra cash in my wallet or in my checking account, I find that I can't help spending it all on Bingo. If I send my spare cash into my bank to prepay principal, the money is safe from my compulsive Bingo urges for the rest of the month. It is a forced savings plan that works well for someone like me who might not be so responsible with the money otherwise.
Bold Bob
My favorite REALTOR and all-around great guy, Matt Difanis, explained recently that the $100,000 that I borrowed to buy my house only has a "real" cost of less than 3% annually. What a deal! I have lots of things I want to do with my money. With my bargain-priced home loan, why would I want to pay that cheap loan off even a day early??!! So long as I can find an investment with an after tax return that equals or exceeds my after-tax mortgage interest rate, I will come out ahead by investing my extra cash in an alternative investment, rather than using that same cash to pay off mortgage principal each month.
But the fun doesn't stop here! I also enjoy the benefit of keeping more of my assets in a more liquid form. If I prepay my mortgage principal, I build up equity in my house faster. While that may be a real turn-on for my neighbor, Nervous Nellie, I see it as having my assets held hostage. Although increasing my equity in my house adds to my net worth, I cannot quickly and conveniently access that equity if I needed fast cash. If I became injured and unable to work, I wouldn't be able to touch that equity without selling my home. Oh sure, I could apply for a home equity loan or a mortgage to get my hands on some of that equity, but if I lost my job, no bank in the world would give me a new mortgage under those circumstances. If I put that extra cash into, say, a total equity index mutual fund that averages a return of 10% per year, I can redeem those shares for cash at any time, allowing me to make my house payment if I found myself in a financial crisis.
While there are arguments to be made on both sides, I generally suggest that anyone with a reasonable amount of self-discipline invest the money elsewhere, unless the person is so risk-averse that she would invest is nothing more aggressive than U.S. Savings Bonds or certificates of deposit at the bank. Even if you don't have tons of self-discipline, you can help yourself by signing up for an automatic funds transfer directly from your checking account into your favorite mutual fund every month. While you can liquidate that investment at any time, you are less likely to fritter away the money on Bingo than if you allowed it to stay in your checking account. It also saves you the trouble of forcing yourself to write a check each month for something that may not always seem necessary. A little planning can save even the undisciplined saver from himself.
Of course, if mortgage interest rates shot up significantly, then suddenly prepaying your mortgage might become the best possible return on your money.
What do YOU think? Hope this helps guide your decision-making.
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Can I get a mortgage that
does not begin with payments that are mostly interest? Can I find a loan
that always has payments with a fixed proportion of interest and principal?
Question via email on April 25, 2000
I have a question I've been tossing around for some time regarding loans. It is especially interesting to me as I look at purchasing a home soon. I'm sure the answer is quite well known out there, though it eludes me and I'm too lazy to research it myself. Here you go:
Naturally I understand the difference between fixed rate and adjustable rate mortgages. Yet even with any fixed rate mortgage (or regular loan for that matter), the % of the payment applied to interest is front loaded over the payment cycle and little is applied to the principal until the end. For example, on a 20 year mortgage with monthly payments of $1,000, you might see payments broken up in a pattern like this:
DATE DEBIT Interest DEBIT Principal
Jan 1, 2000 $350 $650
Jan 1, 2005 $350 $650
Jan 1, 2010 $350 $650
Jan 1, 2015 $350 $650
If there is such a thing, what is it called and how do I get it?
I have never encountered such a loan, and I don't think that either you or I ever will. While your proposed loan structure would be a delight for borrowers, it defies the principle of amortization upon which virtually all modern financing vehicles are based. The word amortize has its origins in the Greek word for "kill." Thus, amortizing a loan literally means to kill a loan. To kill a loan balance, you must first keep the balance from getting larger. This is accomplished by essentially paying rent on the borrowed money. That is, you must first pay the bank the interest incurred during each period that you have the funds--typically months. On a $100,000 loan at 8.5% over a 30-year term, your initial monthly interest payment would be as follows:
$100,000 x (.085/12) = $708.33
So this demonstrates that to merely tread water, you must make a payment of $708.33 each month. This payment, however, would never reduce the amount of the outstanding balance of the loan. In the early decades of the 20th century, this actually was the only available loan type. Called "straight loans" or term loans, the borrowers would make fixed, interest-only payments over the loan term, and they would owe the full original principal amount at the end of the term. This contributed to the epidemic of farm and home foreclosures during the Great Depression. Most borrowers rolled their outstanding principal into a new loan at the end of each term. As the U.S. economy plummeted, banks did not have the funds available to refinance the loans as their terms ended. Many, many borrowers simply could not make the massive balloon payments that were due, resulting in an epidemic of foreclosures.
If the objective is to eventually kill the loan balance over some defined period of time, then you must do more than simply tread water. You must also pay off a bit of the loan principal IN ADDITION to the basic interest payment. In the case of the $100,000 loan described above, the total monthly payment would be $768.91, with the first month's payment including $60.58 of principal repayment. Since your loan balance after the first payment has been reduced to $99,939.42, your next month's payment will be slightly different, with a slightly smaller interest payment and slightly more money from your total payment directed toward reduction of principal. As you can see, you pay off only a tiny chunk of your loan balance each month during the first half of your loan term, while you pay off massive amounts of principal during each month of the last few years of the loan term.
Under the terms described above, here's the score at the end of the 30 years:
Sum of 360 monthly payments @ $768.91 each = $276,807.60
Sum of all interest payments = $176,813.51
Sum of all principal payments = $100,000 (the entire original loan balance)
Your original proposed repayment scheme would call for 360 payments with constant proportions of interest and principal:
$100,000/360 + $176,813.51/360
= $277.78 (principal) + $491.15 (interest)
The only way to accomplish this feat is to have an initially reduced interest rate that rises each month. For the first month's payment to include only $491.15 of interest, your interest rate would have to be lowered to an annual rate of 5.8%. By contrast, when you make your final payment, you would be paying the same $491.15 of interest on a remaining balance of about $277. The effective annual interest rate for that payment would be a stunning 2,121%!!! That makes establishments like Check 'N Go look like a relative bargain!
Since you alluded to the fact that you would likely sell your home in five years, you are essentially asking the bank to let you enjoy the 5% years at the beginning of your loan term, while allowing you to skip out on your 2,000% interest rate catch-up years. If you were a banker, would you go for such a proposition? :-)
EXTRA CREDIT:
Given the standard loan / mortgage front loads payment on interest before principal is reached, does this mean I'm not really building equity at a steady rate? In other words, let's say I take out a fixed interest $200,000 mortgage on a home. I make payments on it for 5 years and decide to sell it and move on. At that time, I have paid back $50,000 of the mortgage, but only $15,000 of that is applied to principal. What is my equity base in the home? In other words, what percentage do I receive from the sale price???? 25% or 7.5%???
Assuming a $100,000 loan at 8.5% amortized over 30-years, your outstanding balance after making 60 monthly payments would be $95,490.53. Thus in the first 17% of your loan term, you would have paid off less than 5% of your original balance. Kind of depressing, isn't it?
Before you become too depressed, consider the following:
If we assume that your total marginal tax rate will be about 30% (28% federal + 2% state), then the effective interest rate is reduced due to the tax deductibility of your mortgage interest. So now your after-tax interest rate is 8.5% x .7 = 5.95%. Now consider that in that same five years that you keep the house inflation averages 3% per year. Now, the "real" cost of your borrowed funds is a bargain-priced 2.95%!
Also bear in mind that renting a home comparable to that which you might purchase would cost you a similar amount in monthly rent; however, you would have no tax deduction and no equity build-up. To make matters worse, any savvy landlord would raise your rent each year to keep pace with inflation. Compare this to your fixed rate mortgage payment, which will NEVER increase by so much as a dime! The only part of your house payment that will rise is your property tax bill and your homeowner's insurance bill, which are pretty insignificant relative to your mortgage payment.
Finally, let me attempt to inspire you with a recent true story of one of my listings client's who sold his home recently:
1. He purchased the house in 1998 for $72,000
2. He used a 97% FHA 30-year loan at 8.0% interest, with an initial balance of $69,840
3. He made 18 mortgage payments, bringing his balance down to $68,947
4. He spent $500 in minor improvements while he owned the house.
5. He put the house on the market 18 months later, and it sold in less than a week at a gross selling price of $83,000.
Here's the return on his investment:
Total investment = 3% down payment + $1000 of closing costs + $500 of improvements
= $2,160 + $1,000 + $500 = $3,660
Net proceeds from the sale = $83,000 - $68,947 (mortgage pay-off) - 7% selling costs
= $14,053 - $5,810 = $8,243
Total gain = $8,243 - $3,660 = $4,583
That total gain represents an annualized rate of return of 55%!! In the meantime, their total monthly housing payment was less than or equal to what they would have paid to rent a comparable property. This example is for a very average house in a modest Champaign neighborhood. Even if these first-time buyers had not lucked into quite that much appreciation, you can see that owning your own home has advantages that go way beyond paying off a few dollars of your mortgage each month.
Did I get the extra credit?
Matt