Your Income and Mortgage Relationship
Your Income and Mortgage are connected in the eyes of your Lender. Understanding how they relate to one another is crucial to your Purchasing Power. This article by Audrey Arkins at Salary.com illuminate some of these important ideas.
Income and Mortgage Size
The first and biggest hurdle to buying your own home is money. Few buyers, if any, try to buy a home without financing because it just doesn't make sense. In addition to the relatively low price of credit in America, why would anyone pass up substantial mortgage interest tax relief? Then there's the opportunity cost. Even the most financially secure among us won't want to tie up hefty capital in real estate when it could be spread across several investments in a diversified, well-planned portfolio.
Typically, home buyers pursue a loan in amounts of 80 or 90 per cent of the purchase price of the house. The remaining percentage is required in cash from the buyer's own savings, and is called the down payment. It's not unusual for lenders to finance up to 95 percent of the purchase price, as long as the client has a steady income and reasonable credit history. The loan or mortgage is usually spread over 15 or 30 years. If you sign on for a 15-year mortgage, you'll get a slightly lower interest rate but monthly payments will be higher (on average, about 27 percent higher than with a 30-year mortgage), but you'll save substantially on interest costs - and own the house outright 15 years sooner.
Deciding what size loan to ask for depends on your financial circumstances. To get a good handle on your suitability for a mortgage will take some accounting homework. Most of the house-buying guides include worksheets, which make the task easier, but essentially it boils down to two key numbers: gross monthly income, and monthly expenses. When assessing your gross monthly income, be aware that only those sources that are verifiable for at least two years are valid with very few exceptions. Typically these include gross salary, bonuses, interest, dividends, social security/pension, and child support. Add them all up and divide by 12 to find your gross monthly income. Now add up a list of fixed expenses. These can include car loans/leases/insurance, student loans, minimum monthly payments on all credit cards, alimony, and child support.
In The Complete Idiot's Guide to Buying and Selling A Home, Shelley O'Hara and Nancy D. Warner estimate that a buyer should plan to borrow "roughly 2 to 2-1/2 times your annual gross salary. If you and your partner make $50,000, you might be able to buy a home in the $100,000 to $125,000 range." The authors advise against a strict interpretation of this ballpark method, since all couples earning $50,000 are not equal. One may have $20,000 in savings and no car payment, which should qualify them for an even higher loan. The other couple, however, might have two car payments, maxed-out credit cards, and no down payment, which won't qualify them for a home in any price range.
The 28/36 ratios
Lenders compare your monthly income and expenses to certain qualifying measures, called the debt-to-income ratio. Most lenders will finance buyers whose monthly house payment (including loan payment, property taxes, and insurance) will not exceed 28 percent of their gross monthly income. But lenders also pay close attention to another measure known as overall debt ratio. This is your total monthly expense including housing, credit card minimum payments, loans, and all other debts. Usually lenders expect this total ratio to fall below 36 per cent of gross monthly income. When you draw up the balance sheet of income to expenses hopefully you'll have an overall debt ratio that won't scare off a lender.
If your debt ratio does exceed 36 percent, take steps to reduce it before you seek a lender. According to all experts, the first step on this path is to stop buying! Anything. Not a DVD, nor a sofa, nor a summer vacation - not a single thing that would create debt of any kind. Most especially, do not buy a car. The absence of a new car payment on an expense sheet can make a huge difference in your favor.
If it won't cut too deeply into your savings for a down payment, pay off minor debts. The less debt overall, the better your ratio. Also, some debts aren't even counted as such if they are due to be paid off in less than six months, so it could make sense to prepay certain debts to get them below the six-month margin.
Whatever money you do have, don't move it around from savings accounts to 401(k) plans or from certificates of deposit to mutual funds. Moving money from account to account will complicate the paper trail the lender will have to scrutinize. It will also show a pattern of recent large deposits and withdrawals, which won't look good. Even if this is your attempt to consolidate your funds, it will actually make it harder for the lender to document properly your source of funds.
- Audrey Arkins, Salary.com contributor