Purchasing a property has several advantages over renting, including lower monthly payments, accumulating equity, and more control. Before you start your real estate search, understand how much money you’ll really need and how you might pay for it.
1. How Much Can You Afford?
The number one reason a mortgage application gets denied is a poor debt-to-income ratio. This is broken down into two common metrics: a housing expense ratio and total obligation.
Housing Expense Ratio This compares monthly housing costs (mortgage, insurance, property taxes) to the applicant’s gross income. As a rule of thumb, your monthly housing cost should not exceed 28% of your monthly gross income
For example, if you make $120,000/year, your gross monthly income would be $10,000. Your housing costs should not exceed $2,800/month (28% of $10,000).
Total obligations ratio This compares total monthly debt payments to the applicant’s income. This would be any debt payments (car loan, student loan, credit card debt, ect) plus housing costs. This ratio should not exceed 36% of your gross monthly income.
2. Down Payment
Generally, if you can put 20% down or more, you’ll receive a more favorable interest rate and avoid having to pay private mortgage insurance (PMI).
PMI is basically buying insurance on yourself for the lender. It protects the lender in case you stop making payments. It can run you $75-$150/month depending on the size of your mortgage.
Where to Save If you are planning to buy in 2 years or less, I would recommend keeping your money in your checking or savings account. If your time frame is longer, you could look at a mix of stocks, bonds, CDs, or other investments.
For the majority of people in their 20s and 30s, their down payment comes directly from savings.
The most used loan is conventional (see below). In this section I’ll go through the most common types of loans.
Conventional Loan is a mortgage from a private lender that meets the requirements for Fannie or Freddie Mac. Typically, you need a credit score of 620, though a score of 740 or higher will help you get the best rate. It is possible to have a down payment as low as 3% but then you’ll have to pay PMI.
Federal Housing Administration (FHA) loans are a type of government loan that allows you to buy a home with looser financial requirements. You may qualify with a FHA loan if you have low debt or a lower credit score.
The downside is you must pay an upfront mortgage insurance premium (MIP), which normally accounts for 1.75% of the base loan amount. You will also have to pay a mortgage insurance premium annually, which can run anywhere from 0.45% – 1.05% of the base loan amount.
VA Loan is a mortgage guarantee by the U.S. Department of Veterans Affairs. Only qualified U.S. veterans, active-duty military personnel and some surviving spouses are eligible. A VA loan can make it easier to buy a home because it typically doesn’t require a down payment.
Although VA loans don’t require mortgage insurance, they come with an extra cost called the funding fee. The fee ranges from 1.4% to 3.6% of the loan. You can pay it upfront or fold it into the loan.
4. Closing Costs
Closing costs are fees paid to the service providers involved with completing your purchase. They typically range from 3%-6% of the home’s purchase price, thus if you buy a $400,000 house, your closing costs can range from $12,000 to $24,000.
Type of fees that make up closing costs: Discount points, loan orientation, underwriting, home appraisal, home inspection, title search fee, title insurance, prepaid property taxes, prepaid interest, recording fees for deed and mortgage.
Buying a property is your largest purchase. It’s a good idea to work with a professional who can help guide you along the way. If you are looking to buy soon, please reach out so we can review your financial plan.
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