You have heard or read about the current real estate market. News has it that properties are selling and prices in many areas are increasing. Along with this news, you know mortgage interest rates are down. This dual combination beckons us to grasp the opportunity that exists to either buy a home or refinance the home currently owned. As you embark on your journey for either, the message is, "get prequalified before you make your offer to purchase" or "how much can you save if you refinance the current loan?" You pick up the phone and call your friendly lender. He or she will walk you through the typical steps of determining how much you can afford to pay each month for housing and how much a lender will lend based upon your total debt obligations.
As I wrote in the past, the questions asked of you may be more important than the questions you pose to the lender. However, if you are shopping for a loan and/or monthly payment, would you like to understand the mechanics of the process? This calculation is not difficult and it is not a secret. As I go through some calculations, I will be using criteria used to underwrite a traditional loan. I will not delve into underwriting guidelines that go beyond the norm. There are so many underwriting options today that confusion can only reign if I go through what is available for individual situations. This is only a primer.
You may have heard the term "debt ratios." The "debt ratio" is the percentage obtained by dividing your debt (housing debt as a separate entity and your housing debt combined with your ongoing monthly installment debt) by your "gross" income. Use your gross income not your "net take home pay." How do you get these figures? "Installment debt" is straight forward. It is your monthly payment for autos, student loans or any other structured payment you may have. "Revolving debt" includes your credit cards. If there is a minimum payment on the credit card, you can use that figure.
To make life easier, you can use 5% of the outstanding balance to figure out your payment. This is usually a higher payment than the minimum payment. Any revolving debt that you pay off in 30 days (American Express card, gas credit card, etc.) may be excluded. These are the basics. If you have other outstanding obligations such as alimony, installment tax payments etc., you must put in those numbers.
Let's now calculate your housing expense. Estimate what you would want to pay for a home. At times, this may be an arbitrary number. Decide your downpayment and the result is your loan balance. Use a computer program like Quicken, an amortization book or a chart available in any bookstore to figure your principal and interest payment.
In California, taxes are based on 1.25% of your home's purchase price for qualifying purposes. If the price is $200,000 your lender estimates the taxes to be $2,500 per year or $208.33 per month. Use this monthly figure in your calculation. Now to fire or hazard insurance payments. I use $3.50 per thousand dollars of loan balance. Assuming your loan balance to be $180,000, your estimated insurance premium is $630.00 per year or $52.50 per month.
Always use the monthly figures when determining your ratios. If you put down less than 20%, you will be required to purchase mortgage insurance to insure the lender in case you default on your loan. This calculation is harder to determine since the premium is based on your downpayment. The larger the downpayment the lower the monthly cost. Use $5.50 per thousand dollars of loan balance to calculate your premium. Divide your annual premium by twelve for your monthly payment. This figure is only a guide.
With the above numbers you have calculated your monthly housing payment. Your payment comprises principal, interest, taxes and insurance. The acronym for this is PITI. The second "I" includes both fire insurance and mortgage insurance. The traditional ratio that lenders and investors looked for was 28%. Twenty-eight percent of your gross income was to be used for housing expenses. Traditional ratios no longer exist.
Once you have your housing payment add to this number the monthly payments for your installment obligations. Your total debt ratio is a result of the addition of housing and installment payments divided by your gross income. Traditional underwriting guidelines say that this number should be 36-38% of your gross income. Using credit scoring criteria, reserves (savings available) after close of escrow and other so called compensating factors these ratios are guides . . . not deterrents.
The lending world has changed over the past years and nothing is as concrete as it once was. Current investment philosophy and risk aversion criteria are different. Lenders and the ultimate investors are taking increasing risks. With greater risks undertaken by the investor, they looked for a commensurate return on their investment. What I reviewed above is how we figure the numbers. It by no means determines the capability of any particular buyer or borrower. Each situation today is reviewed by an underwriter based on individual factors. If you think the time is right for you to purchase or refinance, don't look only to the traditional way for what may be your best opportunity in a long time.
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