Can You Afford?
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.
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
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.
Article continued at http://www.fool.com/homecenter/finance/finance01.htm?ref=start