Protect your Dream Home

by : Christopher M. England

My dream is that we get back to what our Founding Fathers intended for our country - life, liberty, and the pursuit of happiness. Thomas Jefferson borrowed this treatise from English philosopher John Locke. Only John Locke originally called for life, liberty, and the pursuit of property. Every American should have the opportunity to own property and to invest in our nation's future.

No question about it, home ownership pays dividends. Home ownership can be a sign of independence and success. Mortgage interest and property taxes are tax-deductible. You build equity over time which can be used the same as cash. But can you really afford it?

Before you start shopping for a new home, take the emotion out of it. Sure you want that beautiful home in that safe neighborhood with access to those top-notch schools. But what good does it do to hunt for a $300,000 house when you cannot afford to go above $225,000? Shopping for a home within your budget can save a lot of heartache now, as well as down the road.

Caution: How much you 'qualify for' and how much you 'can afford' are different

For starters, a good real estate agent should be able to help you determine how much mortgage you can really afford, and he should be able to put you in touch with reputable mortgage lenders.

When applying for a mortgage, there are several criteria mortgage lenders use to determine how much they will allow you to borrow. That is, if they're reputable lenders. They'll look at your credit score; employment and income verification; existing assets, including cash; existing car leases or loans, credit card balances, debt consolidation loans, home equity loans, installment loans, student loans, and other on-going monthly debts; and the size and source of your down payment.

Reputable lenders check your qualifying ratios to verify how much mortgage you can really afford. More importantly, they do not steer you toward unnecessarily-risky loan products.

As a general rule of thumb, your house-hunting budget should not exceed 2.5 times your gross (pre-tax) annual income. As an example, a family earning $90,000 annually should try to restrict their housing-hunting budget to $225,000.

Your Housing Expense Ratio (principal, interest, taxes, and insurance, or PITI) should not exceed 25% to 28% of your gross monthly income for conventional loans. Your Total Debt Ratio (PITI plus other long-term debt) should not exceed 33% to 36% of your gross monthly income for conventional loans. Other long-term debt includes car leases or loans, credit card balances, debt consolidation loans, home equity loans, installment loans, student loans, and other on-going monthly debts, including alimony and child support. Unfortunately, to make a sale, lenders do not always adhere to these qualifying ratios. As a result, many would-be homebuyers are misguided into believing they can afford a much bigger mortgage than they really can. To make matters worse, some government-sponsored loan programs (e.g., FHA) allow homebuyers to stretch the Housing Expense Ratio from 28 to 31%, and the Total Debt Ratio from 36 to 41%. Typically, loans that exceed conventional qualifying ratios are designed to fail, resulting in higher mortgage delinquencies and foreclosure rates. This problem is exacerbated by abusive or predatory lending practices.

Let's run through a qualifying scenario for the family mentioned above. Using the conventional qualifying ratios, the maximum Housing Expense Ratio the family can qualify for is $2,100 monthly; however, down payments, homeowner's insurance, interest rates, and property taxes ultimately will determine how much the family really can afford to invest in the mortgage itself, as will personal comfort and preference. If the family assumes a $225,000 mortgage with a 30-year fixed rate of 6.25%, the resulting monthly payment for principal and interest will be $1,385. Let's assume property taxes of $272 a month and homeowner's insurance payments of $47 a month. This brings housing expenses to $1,704 per month, excluding private mortgage insurance, well within the qualifying parameters. Although within the parameters, this probably is more than the family really can afford to spend. Do they want to purchase that new boat they've had their eye on or travel to exotic places? Do they want to save for their children's education or for their own retirement? How much does the family want to spend on new appliances, carpet, furniture, etc. for the new home? What about adding a deck or finishing the basement? How much do they want to set aside for savings and investments? How much will the family need for gasoline and car maintenance and repairs? What other long-term debts do they need to pay off? Will they need emergency funds? After all, bigger, more expensive houses lead to higher expenses for maintenance and repairs, property taxes, and utilities. What about medical expenses? The family may want to dust off the calculator or spreadsheet and exercise common sense and fiscal restraint. In any case, the maximum Total Debt Ratio the family can qualify for is $2,700 per month. With a current housing expense of $1,704, the family's other long-term debts cannot exceed $996 per month. Can the family keep their car leases or loans, credit card balances, debt consolidation loans, home equity loans, installment loans, student loans, and other on-going monthly debts below $996 per month? Again, this probably is more than the family really can afford to spend.

What about down payments? When considering how much cash the family will need for a down payment, they cannot forget to factor in closing costs and private mortgage insurance. Closing costs typically run 3% to 6% of the purchase price. Additionally, they will need a down payment of 5% to 20% of the purchase price to avoid paying for costly private mortgage insurance, depending on the lender's preferences. Finally, most lenders will recommend the family keep at least three month's worth of principal, interest, taxes, and insurance in savings at all times, something that will not be easy to do if they are running at the upper limits of the qualifying ratios.

Avoid Lending Gimmicks, Pitfalls, & Traps

Here are a few lending gimmicks, pitfalls, and traps you will want to avoid:

'Your mortgage payment will not increase.' Say what?! How can a $300,000 house not cost more than a $225,000 house? Use common sense. If it sounds too good to be true, it probably is.

'It's a new build. We don't know what the property taxes will be in years two or three.' Say what?! With a new build, your property taxes will be significantly lower in the first year of ownership than they will be in years two or three. An easy way to estimate your property taxes for years two or three is to look up similar-priced houses on the MLS - your real estate agent should be able to provide this information to you.*

'It's a 2-1 buy-down - your interest rate will be 4.5% the first year, 5.5% the second year, and 6.5% for the third and subsequent years. Don't worry about the interest rate moving up in the second and third years. Your income will keep pace with increases in your mortgage payment.' Say what?! For starters, never assume your income will keep pace with rising mortgage payments. This philosophy should be applied not only to buy-down loans, but to other loans designed with initially lower 'teaser' rates. Will you be able to handle the increased mortgage payments when your ARM re-sets to a much higher interest rate?*

'There's a pre-payment penalty.' Say what?! Bottom line: never agree to this, no matter how excited you are about getting the loan. You should never sacrifice the opportunity to accelerate payments to principal, saving significant interest over the life of the loan.

'This is a 'no-doc' loan. We don't need to verify your employment or income.' Say what?! You're not concerned about what I do for a living? That would explain some of my neighbors. You're not concerned about whether I can really afford this house? To make matters worse, some lenders have gone as far as altering loan applications just to make a sale!

'We use our own appraisal service.' Say what?! If the builder's own affiliated or in-house mortgage lender is using its own appraisal service, how can the appraisal be objective? While intentionally overstating the value of a home on an appraisal is illegal, too many homebuyers end up paying far more for their new home than is necessary. Insist on an independent third-party appraisal.

'You don't need an attorney.' Say what?! Not having an attorney check out the mortgage lending paperwork can be costly. Is it worth paying an attorney $150 to $350 to review the paperwork on a $225,000 loan? Yes!

'You should refinance to reduce your monthly payment.' Perhaps. If you have an ARM or other loan designed with initially lower 'teaser' rates that will re-set within the year, refinancing definitely should be considered. For more conventional loans, a common rule of thumb is you should consider refinancing if you can lower your mortgage interest rate by at least 2%. In reality, it's a little more complex than that. Say you're seven years into a 30-year mortgage, and you pay $4,000 in closing costs or fees to refinance and lower your monthly payments by $200. On a straight-line basis, it will take 20 months just to break-even on your closing costs or fees ($4,000/$200.) Additionally, you just re-set the life of your mortgage back to 30 years, meaning you could end up paying significantly more interest over the life of the loan than you would end up paying if you just stuck it out with your current loan (23 years remaining.) Again, it's necessary to dust off the calculator or spreadsheet.

*Ultimately, property tax and interest rate increases are the primary reasons many homebuyers receive mortgage sticker shock after the initial years of homeownership. The home they could afford in the first few years simply isn't affordable any longer. Protect your dream home - insist that the lender calculate your qualifying ratios based on the second or third years of homeownership. Above all, exercise common sense and fiscal restraint.

See for additional resources