Once you learn all of the acronyms and figure out (somewhat) what options you have, it’s time to figure out if you’re actually ready to purchase a home. Unfortunately, for you math haters, it still involves more math stuff. I know, UGH! What are we talking about?
· Money saved for down payment
· Income/Debts
· Credit history and score
· Housing market
· Financial market (lenders)
· Interest Rate
Down Payment
Have you saved any money for a down payment? With the growing inflation in the economy and record amounts of unemployment, a down payment is more important now than ever. Gone are the days where you could borrow more than the value of the home. Lenders are leerier of these scenarios and prefer borrowers with more stability. The more money that you put down for a down payment, the lower your interest rate will be. Let’s talk a little about how this works. The interest is not only dependent on the market, but also on the loan to value (LTV), which is the amount of the loan compared to the sales price (or appraised value, whichever is lower). The higher the LTV, the higher the interest rate will be. The lower the LTV, the lower the interest rate. Let’s look at this with an example. If you want to purchase a home for $100,000 and have only $5,000 to put down, your LTV would be 95% ($95,000 ÷ $100,000). With each incremental increase in the loan to value (LTV), your interest rate typically increases as well. Let’s look at some typical LTV ratios.
Typical LTV ratios:
· 80% and below
· 80.01%-90%
· 90.01%-95%
· Greater than 95%
**Always consult a local lender for specifics relating to your individual case.
The reason that you pay more when you borrow a high percentage of the home value is the fact that the lender is at more risk. This, in turn, makes them feel uncomfortable. Their worry is a foreclosure scenario. If you go into foreclosure and there isn’t enough money to pay for the loan, they will not receive all of their money. For example, you received a $95,000 loan in 2019 on a home valued at $100,000. In 2020 you go into foreclosure and the home is subsequently sold for $90,000 on an economic downturn and reduced market. You owe $95,000, but only have $90,000 minus any other expenses. Instead of making money as the lender was hoping when they loaned you the money, they lost money. Risk = reward so if their risk is lower, they will charge you a lower interest rate. Owing more than the current value is referred to as being “upside down” in the asset.
As a homebuyer, whether it’s your first home or fifth, you want to make sure that you can put down as much money as possible. This not only makes the lender more comfortable, but it also reduces the monthly payment. Simply said, the more you borrow, the higher your payment and interest rate. To obtain a lower interest rate in the market, put down a larger down payment. This may mean that you need to wait another year to purchase a home than you had originally hoped to do. It will be better in the long run.
The first thing you need to do when purchasing a home is to get a pre-approval from a lender. Typically, lenders will do a prequalification for a potential borrower. This means looking at a borrower’s credit report to determine their “credit worthiness” for the amount that they can afford to pay each month. It’s contingent upon nothing changing at that snapshot in time.
An important thing to remember is that just because the borrower can financially qualify for a loan payment of $2,240 in our example, it doesn’t mean that you have to become that extended financially. Especially with the recent downturn of the economy after the pandemic, it’s best to keep your debt below your means. Even if you can afford to purchase a $600,000 home, doesn’t mean that you should.
Income/Debts
Your income and debts are a significant deciding factor on how much you can borrow. Your DTI (Debt to Income Ratio) will determine what kind of loan you will be approved for. There is a front and back-end DTI. The front-end is calculated by taking your monthly proposed home debt (PITI-Principal, Interest, Taxes, and Insurance) and dividing it by your monthly gross income. The back-end is calculation by all of your monthly debts divided by your monthly gross income. Both of these calculations yield a percentage. Each loan has different DTI requirements. Even though they vary considerably by lender and program, we will discuss the generic amounts here.
Conventional loan rates are 38/45, FHA loans are 37/50 and VA loans are 29/41. See below for explanations of these types of loans. These amounts can vary per lender and situation, credit, down payment, etc. *Check with your local lender for your specific calculations and restrictions. See Breaking Down Home Purchasing Terminology (6/3/21) for more specific details and descriptions. https://realpamelaferguson.wixsite.com/website/post/breaking-down-home-purchasing-terminology
An example with numbers might help it be more clear.
Annual Income: $85,000 or $7,083/month
FHA loan with DTI of 38/45: front end DTI of $2,691 ($7,083 x .38), back-end DTI of $3,187 ($7,083 x .45). To qualify for this FHA loan That means that your PITI mortgage payment must be less than $2,691 and your total debts (including your proposed mortgage payment) cannot exceed $3,187.
Credit History and Score
The underwriter at the lending company will look at your credit score, income, and debts. Depending on the lender, they may have loan to value ratios (LTV) that correlate to your credit score. Other lenders will look at the overall picture. If you have too much debt, you may need to either pay down debt or put down a larger down payment.
Your credit score can make a difference whether you can get a subprime or prime loan. Borrowers with good/excellent credit are able to obtain a prime loan where they are able to have marketable interest rates. Borrowers with this level of credit are able to choose from many loan options and types. If your credit report is less than stellar, you may fall into the subprime area. This is for people who have had repayment issues and perhaps even previous a foreclosure or bankruptcy. If you have had issues in the past, it doesn’t mean that you can’t get a loan, but you will have to pay a higher interest rate for that loan. Lenders see you as a bigger risk, so to offset that, the interest rate will be higher than a prime loan. See the blog Credit Score and How it Effects Your Finances from 6/1/21 to discover a more in-depth discussion on the ins and outs of your credit score. https://realpamelaferguson.wixsite.com/website/post/credit-score-and-how-it-effects-your-finances
Housing Market
The housing market has a major impact on whether you should buy or sell at any given moment. Currently, in our economy, we are in a seller’s market. What that means is that houses are selling above “market value” or at least the price that they were valued at only 2 years ago. Coupled with high demand, it is a great time to sell.
Conversely, it’s not a great time to buy; however, if you have to sell, then it’s a wash. You usually only “win” on one of the ways. Unfortunately, when you are buying and selling, you can’t win both ways. If you sell high, you probably have to pay high. If you sell low, you’re probably able to get a good deal on another home. Your hope is that the savings that you get on your purchase is more than the loss you’ll have to take on the sale.
Financial Market
The financial market refers to the current state of the economy and the real estate market in general. Interest rates, availability of properties, number of buyers/sellers, inflation, the stock market, bond supply, availability of funds for the lender, and others.
Interest Rates
As mentioned, the market interest rates are another determiner to help you decide whether it’s a good time to purchase or even refinance a home. When interest rates are low, it means that there is more money available to lend to borrowers in the open market. More money to lend means lower interest rates to attract borrowers to get that money. When interest rates are high, it means that there is less money available to lend to borrowers in the open market. Less money to lend means higher interest rates because they don’t want an overabundance of potential borrowers where they don’t have enough money available to lend.
Ideally a borrower wants to purchase a home when rates are low. Unfortunately, due to a lack of down payment or various other reasons, people are not always able to purchase when the market is low. Real estate is cyclical. It may be a seller’s market now, but for the past several years, it has been a buyer’s market. An economic (financial) benefit of real estate is that it is a permanent investment. That means that the piece of land that you own has value. Regardless of drops or increases in the real estate market, there is intrinsic value in land. Building structures may come and go, but the land remains making it a permanent investment which is attractive to many investors.
If you have “extra” money, real estate is an excellent investment. Of course, I mean holding the land for a long time and not expecting a quick return. As mentioned, real estate is cyclical and there will be depressed and large growth times. Think of it as a long-term investment and you’ll be fine.
Let’s delve into factors that affect your interest rate as per www.consumerfinance.gov.
Credit Score
Your credit score is one of the most important parts of determining your interest rate. The higher your score, the more comfortable the lender feels with allowing lower rates. Risk versus reward for their perspective. If you are a borrower with a great credit score, many lenders will want you, so a lower interest rate can be used to attract you. Conversely, if you have a low score, you (as the borrower) are desperate to get a loan so the power is in the hands of the lender. They don’t feel as comfortable with the situation so they need to have a higher interest rate to make up for the risk of a borrower with less than stellar payment history.
Home Location
The area of the country that you may live is a significant factor in determining interest rates. Always get a second/third quote. Shopping around is important. Use your own power.
Price of Home and Loan Amount
As mentioned before, the more money you borrow, the higher the interest rate will be. The less LTV (loan to value) that they lend, the more comfortable they feel. Loan to value is the amount borrowed divided by the appraised value/purchase price (whichever is lower). Example, a loan amount of $95,000 with an appraised value of $100,000 is a loan with an LTV of 95%. Extra large or small loans also may come with a higher interest rate. Lender is more extended with larger (JUMBO) loans and it’s not worth their effort on very small loan amounts.
Loan Term
The shorter your term, the lower your interest rate. You’ll hear many recommending a 15-year mortgage instead of a 30-year due to paying it off quicker and having a much lower rate. This also applies to other loans. A good rule of thumb is to try not to have a length of more than five years on a car loan.
Interest Rate and Loan Type
In my previous blog Breaking Down Home Purchasing Terminology (6/3/21) https://realpamelaferguson.wixsite.com/website/post/breaking-down-home-purchasing-terminology I go into more in depth with FHA/VA/Convention loans and discuss ARM loans and conventional loans that discuss the different types of loans.
Making a home purchase is a very big and important life decision. It may be the biggest financial decision that you make in your entire life. There are experts that can help you along the way, but having a familiarity with the process will only make it easier and less stressful and confusing for you.
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