Financing Your First Home
Step 2 - Getting a Mortgage and Deciding How Much to Borrow
If you missed part 1, see the previous article.
Qualifying for a Mortgage
One big fear of all first time homebuyers is that they won’t qualify for a mortgage. Lenders are concerned with only two things: your ability to pay off the mortgage they extend to you and your ability to do so in a timely fashion. Banks have a limit on how much credit they can extend balanced against their holdings, so the issue of a long-term loan, usually a large one, is evaluated carefully. Generally speaking, banks will calculate the maximum mortgage they will grant a lender as:
Mortgage Payment + Property Taxes + Insurance = X
Two big omissions are start-up repairs and ongoing maintenance. These expenses, no matter how inevitable, do not figure into the calculation. As the buyer, however, you have to include it your budget. Usually, if X is less than 28% of your gross monthly income, your loan will be approved.
Two variables in this equation are the stability of your income and the status of your other debts. If you are an entrepreneur, you will have to jump through more hoops than someone who is salaried – even if they produce less income in a year than you.
Your Credit Rating
Finally, lenders will check your credit rating and your other debts to set an interest rate. They do this because other debt obligations lessen your chances of paying off the loan in a timely fashion and increase the chance that you will default due to the pressures of meeting multiple payments from various lenders. The classes of debt follow personal finance lines, with high-interest loans being worst and low-interest, tax-deductible loans still being bad, but forgivable. If possible, retire as much debt as possible before applying for a mortgage. After the credit crunch of 2007, banks have tightened their lending requirements considerably.
How Much Should You Borrow?
Although your home is one of the biggest purchases you will make in your lifetime, you don’t want to own a home that cripples you financially and determines much of your future spending. Alternatively, you probably don’t want to skimp on your home and spend a number of years in a dump you don’t like. An easy solution is to get a pre-approved mortgage before setting your sights on a home. This will keep you within a range that, while set by strict lenders, is probably appropriate for your current income level.
Just because you have a pre-approved mortgage, doesn’t mean you should filter out homes listed above that amount. Many homes are listed higher than their final sales price. Similarly, if you have good credit and a steady job, many lenders will offer big money mortgages. This doesn’t mean you should use the entire mortgage you are approved for - you have to put priority on your overall financial situation. You are not just buying a house, but all the fancy things to fill a house with. If you tie up all your disposable income in mortgage payments, you will be sorely tempted to buy the bells and whistles on credit – leading to more and more of your income going to service debt.
Getting Your Tax Savings Now!
As soon as you have finalized the purchase of your new home (the next article will look at searching for an appropriate home), you will want to get your taxes adjusted. Most people leave this until filing time, whereupon they get a healthy refund. Although such a large refund feels nice, what you have actually done is to give the IRS an interest-free loan and robbed yourself of more disposable income or any returns you would have had if you invested the money over the same period.
Mortgage interest and property taxes are tax deductible via Form 1040, Schedule A. When you buy a house, you should have your withheld income amounts adjusted immediately. If a company employs you, you need to ask your payroll department for a Form W4. If you are self-employed, you will need a Form 1040 ES. You can get a copy of the form by calling 800-TAXFORM and having them mail you one.
Buying the House You Can Afford
In the industry lingo, the buyer is usually motivated by, “getting the most house for your dollar.” The pitfalls of this approach are numerous, mostly because making the house your foremost priority is a sure way to ensure it will be your number one financial priority for the next 15-30 years of scraping together payments. Two ways to avoid being controlled by your mortgage are to get a pre-approved mortgage and purchase a house that fits within your overall financial situation. Although a lender will give you a mortgage that can use up to 30% of your gross income, most people would be better served by keeping the actual payments below a quarter. In addition to shelter, you still need food, clothing, and some money to save for a rainy day and the leaky roof it may expose.
