From How Much You Make to A Payment You Can Afford

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I'm clueless about how home loans work. Is there any way to figure out how much I can afford to spend per month on a home. If I were to get a home for $(figure) how much would that be per month? How do I know how much the interest will be? Any sites that explain it all in layman's terms? Thanks

It's actually pretty easy. You are allowed a certain percentage of your gross monthly salary for debt service and housing. According to Fannie Mae and Freddie Mac, who control A paper, it's essentially 45%. Some sub-prime lenders will go to 60 percent, but let's stay A paper until we know you don't qualify.

Lest it not be obvious to you, the less debt you have currently, the more you can afford to take on for a housing payment. One of the real problems, and reasons for abuse of a stated income loan, is couples who make $4000 per month each, but have $1200 or $1500 or $2100 in monthly payments for the two cars, credit cards, student loans, etcetera. Their coworkers all have $3000 mortgage payments, and $3000 buys a lot more house than the $1800 which is all they can afford. Actually, it's a pretty critical difference right now, since $1800 is the payment on about $275,000, which when I first wrote this, bought a decent two bedroom townhouse in an okay area, or a rotten three in an awful area, while $3000 is the payment for about $450,000 or a little more, which could have bought a 3 or maybe 4 bedroom home in a decent area.

Take 45 percent of your gross monthly income, call it X. From X, subtract your current debt service. This is car payments, credit card payments, furniture payments, any actual debt you have.

The number that is left over, call it Y, is what you can afford for housing by traditional measures. It needs to cover principal and interest of the loan, property taxes, home owner's insurance, and association dues (if any), PUD fees (if any), and Mello-Roos (if any).

Assuming that there are none of the last three, you're left with PITI, the acronym you're going to hear about what this covers: Principal and Interest (on the loan), Taxes (property) and Insurance (home owner's insurance).

When I first wrote this, there were A paper thirty year fixed rate loans in the low sixes with 1 total point or less (rates are a bit lower at this update). Any loan calculator (except auto loans) can handle that calculation. Except that if you're not putting a down payment, you're going to want to split your loan into a first and a second to avoid PMI (Unfortunately, as of this update, second mortgage holders have run for the hills. It's one loan with PMI or nothing at all). To do this, you're only going to put 80% of your loan on the first mortgage. Adding the remaining 20% back in at 9.00% (doing this saves you about two and a quarter percent on the whole amount), for which you're going to need to do a separate calculation. Put the two numbers together and that's the principal and interest (PI) part of the PITI acronym. This assumes you've got decent credit, by the way.

I have no way of knowing your property taxes. Every state in the union has their own way of doing it. California's is actually one of the lower tax rates, considered on an assessment per unit of value basis. There are also zones where bond issues have passed, Mello Roos assessment districts to pay for the costs of bringing utilities to the development, and so on and so forth. Your county assessor will have the details. One of the things a good agent can often do here in California is deduce the presence of assessment districts based upon the taxes paid by a particular property, but it's subject to error, and your county assessor's office will have the information, and it won't b subject to guesswork.

I have no real way of knowing what home owner's insurance might be. I usually guess $100 to $110 per month for a good policy covering detached housing, but that's a guess, and it could be much more, or slightly less. The only way of moving from guess to certainty is to ask insurance agent how much to insure a given property.

Now, if the sum of these numbers (PITI) is less than $Y, that portion of your monthly income available for payments and left over after monthly debt service, you've got an excellent chance of qualifying for that loan. If not, you're going to either not buy the property or have to go sub-prime, where the allowed debt to income ratio is higher, but the rates will also be higher and the terms less generous, for instance in the presence of a pre-payment penalty. It is likely that instead of playing games to stretch your ability to qualify, you would be better off shopping for a less expensive property in the first place. But that's a hard thing to get most buyers to accept. They've fallen in love with the brand new house and they don't want to hear that they can't really afford it. The universe knows that these good deeds do not go unpunished. But informing the client is still the right thing to do.

Caveat Emptor


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This page contains a single entry by Dan Melson published on May 3, 2008 7:00 AM.

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