The past few weeks we have focused on loans that you will likely have to think about in the very near future. Perhaps a little farther off is another loan: a mortgage. At some point in your life, you’ll probably want to buy a house. According to the U.S. Census Bureau, the average cost of a new home (including land) in December 2013 was $311,400 and the median cost was $270,200. Not many people have that much money on hand, which makes mortgages incredibly useful.
The most common type of mortgage is a 30 year fixed rate mortgage. This means that a homebuyer makes monthly payments to the bank for 30 years before they actually own the home. “Fixed rate” means that the interest rate will never change during the 30 year period. Because the homebuyer does not own the house, should he or she fail to make payments the bank can reclaim the property and sell it in an effort to make back the money it loaned the homebuyer. This is known as foreclosure.
In order to avoid foreclosure, you must first ask yourself what you can afford. How does a mortgage fit into your budget? One tool that lenders use to determine how much individuals can afford is called the debt-to-income ratio. Lenders will look at both your front-end ratio and the back-end ratio. The front-end ratio tells them what percentage of your income will go toward mortgage payments each year; this includes the principal, interest, insurance and taxes. A good rule of thumb is that the front-end ratio should not exceed 28%. For example, if you make $40,000 a year, your monthly mortgage payments should not exceed $933.
(40,000 * 0.28) / 12 months = $933.33
The back-end ratio tells investors how much of your total income is needed to fulfill all of your debt obligations. This includes your mortgage, car loans, student loans, credit card bills, etc. This ratio should not exceed 36%. Using the example from above, your total debt payments should not exceed $1,200.
(40,000 * 0.36) / 12 months = $1,200
A lender will also look at a potential buyer’s credit score, which we will discuss in depth next week. The higher the score, the easier it is to get a mortgage.
There are a few more things to keep in mind when buying a home. First, the traditional down payment required is 20%. You would need more than $54,000 to put a 20% down payment on a $270,900 home. According to Freddie Mac, the average interest rate for a 30 year fixed rate mortgage is 4.53%. If you put down the 20%, you’ll be looking at payments of over $1,000* after real estate tax and homeowners insurance are accounted for. Notice that this amount exceeds the $933 limit set by our front-end ratio. Make sure you have realistic expectations and limit yourself to homes that fall within your budget, not homes that compare with the national average. Also, check sources like American FactFinder, which includes the American Housing Survey, to determine average housing costs for the city in which you’ll be living.
If you’re looking for more information, check out the two Spending on Housing chapters in Who’s Buying by Age, available online through Andersen Library.
*If you’re wondering how I got the monthly payment amount of over $1,000, try a few of the mortgage calculators listed below. I used $696 for my average annual homeowners insurance amount and $1,812 for my average annual real estate tax amount (numbers based on median amounts payed by Americans in 2011):
Note: This blog post is for informational purposes only. No content should be construed as financial advice.