The first step in finding a home is figuring out how much you can afford to spend. This
probably means you're going to need to borrow money, and that is what getting a mortgage is all about.
Taking out a mortgage is probably the biggest obstacle facing prospective homeowners. The
bank may not want to lend you as much as you need. This is a big problem for you, but
there's a reason for it. Put yourself in the bank's shoes: If you were going to lend people
money, what would you want to know about them? Basically, you'd like to know 1) if they make
enough money to pay you back, 2) if they've been trustworthy in the past, and 3) if they
have something of value should they be unable to pay you back.
Congratulations: In financial parlance, you've just been introduced to the concepts of
income, credit worthiness, and collateral. Let's look at each
one.
Do You Make Enough to Pay the Lender Back?
Your lender will want to know not only how much money you have, but how much you will likely
make over the next 30 years. Also, what are your other debts? Do you owe money for college
or on credit cards? Do you
have any other assets?
Things like stocks and mutual funds or real property like a boat or a car are also
considered in figuring out how much a bank will lend you.
In general, the lender will want you to come up with at least 20% of the value of your new
home for a down payment before they will give you a mortgage. But, there are special
financing arrangements for which you probably qualify that will get you into a new home for
as little as 3% of the asking price. We'll talk more about mortgages and those special
programs later in our home-buying area.
The lender will also plug your income numbers into a couple of formulas: the front-end ratio (having to do
with your mortgage payments) and the back-end ratio (having to do with your debt).
Let's say your gross income is $4,000 a month, and you have $1,000 a month in debt payments.
The rule of thumb is that they'll allow you to pay 29% of your gross income toward your
mortgage payment every month. This is known as the front-end ratio. In this example, 29% of
$4,000 is just under $1,200 a month -- so, they'll reason, you can put $1,200 toward your
mortgage payment.
Your debt ratio or back-end ratio, on the other hand, is 1,000/4,000, or 25%. That's not
bad. They don't want more than 41% going to your other debt. (These ratios can vary
somewhat; the ones given here are good examples).
Have You Been Trustworthy in the Past?
What is your credit rating? The three major credit reporting agencies are Experian (formerly TRW), Equifax, and Trans Union. For
about $8 each (less in some states) you can order reports directly from their websites.
These reports will indicate whether you have a couple years' history of paying your bills on
time.
If not, there are ways to clean up your credit record that will make you more attractive to
lenders. Check out Settle Your
Personal Finances in our 13
Steps to Investing Foolishly for some tips on how to get your financial house in
order.
Do You Have Something to Use as Collateral?
In case you can't repay the loan, the bank can decide to do something really nasty:
foreclose on the mortgage and repossess the house. That means they own it, and you no longer
do. You then find yourself out on the street with your dog and your La-Z-Boy, your
collection of unpublished poetry, a couple of suitcases, and your toiletry kit. Your house
now belongs to the bank, and it is unlikely that anyone will ever loan you money again. Hot
tip: Avoid this scenario at all costs.
The above three considerations are from the bank's point of view. Now, let's take a look at
a few things from your point of view.
Your Timeline
In determining whether you should buy a new home, think about how long you're planning to
stay in it. It generally doesn't make economic sense to buy if you are planning to stay
there for less than four years. Why? Because you're going to be paying fees to buy and then
to sell your house. It would have to appreciate in value very quickly between the buying and
the selling to make it financially worthwhile. In other words, you'd have to get lucky.
Your Comfort Zone
Before you borrow $90,000 or $200,000 or whatever the amount is, figure out whether you can
really afford it. Just because the bank will loan it to you doesn't mean that you will live
your life in such a way as to be able to pay it back. Are you planning on having a big
family? Would you rather replace your Cavalier with a new Mercedes? Your house payment is
just one piece of your financial puzzle. What might you need to give up to make that house a
reality?
As part of our collection of tools to help you in your home purchase, we've made a personal worksheet that
you can use to get an accurate snapshot of your financial state. This is for your own use;
we've put together another one that will more closely mirror the information that a prospective
lender will want.
Should You Rent Instead?
What if you're renting? Would you be better off in a home you own, from a month-to-month
financial standpoint? As we'll see, there are tax advantages that make buying a home more
affordable than you might imagine. In fact, click on our Fool calculator to get an answer to
the question, "Am I
better off renting?" Then, if the answer to that question is "No," click on over to
another handy, dandy Fool calculator to figure out just how much house you can
afford.
You may be pleasantly surprised. Now let's move on to the next step, which is all about mortgages.