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The first step in finding a
home is figuring out how much you can afford to spend. We'll
look at six different factors to consider when making this
decision, with three of them related to mortgages, and the
other three focused on broader personal considerations, such
as how long you plan to own the home.
The Mortgage
Taking out a mortgage is probably the biggest hassle facing
prospective home owners. The bank will want to ask you all
sorts of nosy questions about your income and savings (or
lack thereof), and then might not even lend you as much as
you need. The nerve!
Of course, there is a reason for this. 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, and how they affect what you can afford.
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
loans or credit card charges? Do you have any other assets?
Things like stocks and mutual funds or personal property like
a boat or a car are also considered in figuring out how much
a bank will lend you.
Ideally, you will want to come up with at least 20% of the
value of your new home as a down payment, to avoid things
like mortgage insurance payments. But, you probably qualify
for plenty of financing arrangements 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.
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
$400 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
$400/$4,000, or 10%. That's not bad. They don't want more
than 41% of your gross income going to total debt -- mortgage,
credit card interest, and other payments -- and in this case
you're paying 39% towards that purpose. (These ratios can
vary somewhat; the ones given here are just examples).
Have you been trustworthy
in the past?
What is your credit rating? The three major credit reporting
agencies are Experian, Equifax, and Trans Union. You can request
credit reports individually from each agency -- or order from
all three agencies in one easy step at TrueCredit.com. Before
you order your report, we suggest you check out A Fool's Guide
to Credit Scoring for an overview of the credit scoring process
and tips on how to maximize your credit score.
Your credit report -- a nifty little compilation of your personal
financial history -- will reveal whether you have a track
record of paying your bills on time. If not, there are ways
to clean up your credit that will make you more attractive
to lenders. We walk you through the steps in the Settle Your
Personal Finances section of our 13 Steps to Investing Foolishly.
Do you have any collateral?
The house you buy will generally be considered collateral
for your mortgage. As a result, 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. You will find yourself
out on the street -- with your dog, your La-Z-Boy, your collection
of unpublished poetry, a couple of suitcases, and your toiletries
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.
Your Considerations
How much you make, your creditworthiness, and how much collateral
you have are all questions from the bank's point of view,
because how much house you can afford is largely a question
of how big a loan you can afford. Now, let's look at a few
things from your point of view.
Your Timeline
To determine 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 only planning to stay
there for a couple of 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 time
you buy it and the time you sell it to make it financially
worthwhile. In other words, you'd have to get lucky.
Your Comfort Zone
Before you borrow $90,000, $200,000, or whatever you need
for your mortgage, 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 to have a big family? Would
you rather replace your Chevy 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
and are you really willing to do it?
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 situation. 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. Head on over to 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. |
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